Between 1984 and 1996 the Government of the United Kingdom privatized 32 state-owned utility companies. The Government then instituted a one-time twenty-three percent tax, called a "windfall tax," on the privatized companies based on the difference between each company's profits and sale price. Petitioner PPL Corporation, an energy company, owned a 25 percent share of one of the utility companies that the Government of the United Kingdom privatized. After PPL Corporation paid the tax, it filed a tax claim with the Internal Revenue Service, asserting that PPL Corporation was eligible for a foreign tax credit under Internal Revenue Code § 901, but the Internal Revenue Service denied PPL Corporation's claim. PPL Corporation argues that the windfall tax targets income and therefore qualifies PPL Corporation for credit under § 901. PPL adds that the calculation of the tax involves the value of the company’s net gain. The Commissioner of Internal Revenue argues that the tax is not a tax on income per se but rather a tax on the value of a company. The Commissioner adds that the calculation of the tax measures the ability of a company to generate income. A holding for PPL threatens to undermine the consistency and uniformity of the U.S. tax code as well as curtailing the power of the Commissioner of Internal Revenue to interpret the law. However, a holding for the Commissioner may subject taxpayers in PPL’s position to double taxation.
Questions as Framed for the Court by the Parties
To avoid double taxation, section 901 of the Internal Revenue Code allows U.S. corporations a tax credit for income, war profits, or excess profits taxes paid to another country. This case involves application of section 901 to a "windfall tax" imposed by the United Kingdom. Although it is undisputed that the tax's practical effect is to impose a 51.75% tax on the "excess profits" certain companies earned in the four years after they were privatized, the Third Circuit-at the Commissioner's urging-deemed the tax non--creditable because the U.K. statute nominally taxes the difference between two numbers, one of which is driven exclusively by profitability during the four-year period, rather than nominally taxing the profits themselves. In a case arising out of the same U.K. tax, same tax court proceedings, and same evidentiary record, the Fifth Circuit reached the opposite conclusion and affirmed the Tax Court's considered view. Recognizing that it was creating a clear circuit split, the Fifth Circuit affirmed that courts must look beyond the form and labels of a foreign tax statute and consider the tax's practical operation and intended effect when determining whether it is creditable for U.S. tax purposes.
The question presented is:
Whether, in determining the creditability of a foreign tax, courts should employ a formalistic approach that looks solely at the form of the foreign tax statute and ignores how the tax actually operates, or should employ a substance based approach that considers factors such as the practical operation and intended effect of the foreign tax.
Should a U.S. company receive U.S. tax credit for paying the United Kingdom’s windfall tax?
Petitioner, PPL Corporation ("PPL"), is an energy company headquartered in Allentown, Pennsylvania, which provides electricity and natural gas to consumers in the United States and the United Kingdom. In 1997, PPL held a 25 percent stake in South Western Electricity Board ("SWEB"), a United Kingdom utility company that the Government of the United Kingdom ("U.K. Government") privatized in the 1980s. The U.K. government had privatized 32 companies between 1984 and 1996 in order to increase the efficiency of the companies. In 1997, the U.K. Government imposed a one-time windfall tax on privatized companies based on the difference between a company’s value, established by that company’s profits over a certain period of time, and the "flotation value" or amount at which the U.K. Government sold the company. After paying its share of the windfall tax, PPL filed a tax claim with the Internal Revenue Service ("IRS") asserting that under § 901 of the Internal Revenue Code ("I.R.C. § 901") PPL was entitled to a refund, or "foreign tax credit," on the tax it had paid to the United Kingdom, according to the portion of the windfall tax that the company had paid.
In 2007, the IRS denied PPL’s claim, contending that the windfall tax did not qualify for the credit, meaning that the tax was not creditable as a foreign tax under I.R.C. §901. Consequently, PPL filed a petition in the United States Tax Court ("Tax Court"), arguing that the windfall tax was a foreign tax that qualified for a foreign tax credit. The Tax Court held that PPL was entitled to a foreign tax credit because the windfall tax was essentially a tax on excess profits and thus fell within I.R.C. § 901(b). The Commissioner of Internal Revenue ("Commissioner"), appealed the Tax Court’s decision to the United States Court of Appeals for the Third Circuit ("Third Circuit"). The Third Circuit reversed the Tax Court's decision, holding that the windfall tax did not entitle PPL to a foreign tax credit because the windfall tax was a tax not solely on SWEB's profits but instead on the difference between its profits and sale value. On July 9, 2012, PPL contested the decision of the Third Circuit and filed a writ of certiorari to the Supreme Court of the United States, which granted review on October 29, 2012.
Petitioner PPL Corporation ("PPL") argues the Supreme Court should adopt an approach that considers the actual as well as the planned function of the foreign tax—a substance-based approach—to decide whether PPL is entitled to a foreign tax credit ("credit") under I.R.C. §901. Specifically, PPL claims that under a substance-based approach, the windfall tax qualifies for a credit. Respondent, the Commissioner of Internal Revenue, rejects the Petitioner's substance-based approach and argues instead that the foreign tax that PPL had to pay was not an income tax and thus does not fall under I.R.C. § 901. According to the Commissioner, the Petitioner's reliance on the substance-based approach incorrectly assumes that any tax that depends on net profits, as the windfall tax does, is an income tax.
Resolution of a Circuit Split
Although the United State Court of Appeals for the Third Circuit ("Third Circuit") decided that the windfall tax does not qualify for a credit, the United States Court of Appeals for the Fifth Circuit ("Fifth Circuit") decided, in a similar case, that it does qualify. The Fifth Circuit held that Entergy, an energy company, was entitled to a credit after the U.K. Government collected the windfall tax from a company that Entergy owns. Acknowledging that the Third Circuit had reached a completely opposite holding, the Fifth Circuit relied on the substance-based approach and found that the intended and actual functions of the windfall tax tipped the case in Entergy's favor. Currently, the Solicitor General's petition challenging the ruling for Entergy is pending the decision in this case for PPL. Thus, the Supreme Court's decision in this case is significant because the Court's holding will resolve a circuit split. Resolving the circuit split will provide a single interpretation of federal law, specifically the Internal Revenue Code, to all of the circuits and promote consistency among the circuits in terms of credibility of foreign taxes.
Effect on Similar Cases
Other companies besides PPL have paid the windfall tax and therefore will be affected by the outcome in this case. For example, American Electric Power Company, Inc. ("AEP") owned two different companies that were both subject to the windfall tax. Although AEP received a foreign tax credit for one of the companies, it currently disputes the IRS determination that the foreign tax credit does not extend to AEP's second company. Therefore, AEP and other similarly situated taxpayers in the United States will be impacted by the Supreme Court's decision as to whether the windfall tax does indeed qualify for a credit. According to a prior holding of the U.S. Tax Court, the purpose of having a foreign tax credit is to ensure that American companies conducting business in other countries are not forced to pay taxes in both the United States and a foreign country, which is known as double taxation. Therefore, these companies, including AEP, raise concerns that a decision in favor of the Commissioner will mean that they will be subject to double taxation for foreign taxes on excess profits, placing unfair economic strain on the company. The Commissioner asserts however, that the windfall tax was not simply a tax on excess profits and so is taxable in the United States without a foreign tax credit for companies like AEP. If the United States cannot tax these companies it not only will be losing money but will also lose its economic regulatory control over the companies.
Impact on Constitutional Rights and Liberties
Proponents of PPL's argument contend that a decision in favor of the Commissioner would hurt the property rights of businesses and liberty interests. For example, the Southeastern Legal Foundation, Inc. ("SLF"), a constitutional public interest law firm, contends that denial by the Supreme Court of a credit would subject companies to double taxation, economically burdening those companies with more than their fair share of taxes. Similarly, the Cato Institute ("Cato"), a public-policy research organization, claims that affirming the Third Circuit's ruling for the Commissioner would restrict constitutional liberties by imposing double taxation on companies like PPL while limiting the power of the courts to keep government agencies in check. The SFL, Cato, the Goldwater Institute, and the Chamber of Commerce of the United States of America argue that if the Supreme Court adopts a formalistic approach to the issue in this case, businesses will have less control over their property while the power of the Commissioner expands. In response to these concerns, the Commissioner argues that the U.S. government is well within its power in interpreting the statute and that denying PPL a credit does not lead to double taxation on PPL. The Commissioner asserts that PPL's interpretation of I.R.C. § 901 would promote inconsistency in the U.S. tax code as to how much of a foreign tax credit should be granted because each of the companies were sold in the U.K. at different values regardless as to whether they earned a profit. According to the Commissioner, some companies escaped the windfall tax altogether despite their profits because they were sold at prices higher than their earnings. The Commissioner cautions that granting PPL a foreign tax credit would muddle the explicit meanings of terms within both the U.K. and U.S. tax codes.
According to Petitioner PPL Corporation (“PPL”), the United States offers tax credits to provide uniformity of tax burdens regardless as to whether a taxpayer engages in business dealings abroad and to ease the operations of the foreign branches of U.S. companies. Section 901(b)(1) of the Internal Revenue Code (“I.R.C.”), formulated by Congress, provides tax credits for taxpayers’ “income,” “war profits,” and “excess profits.” PPL argues that the substance, rather than the form or label, of the United Kingdom’s windfall tax should determine U.S. tax law creditability because the predominant character of the windfall tax is that of a tax on “income,” as the term is defined under U.S. tax law. The Respondent Commissioner of Internal Revenue (“Commissioner”) argues that the windfall tax does not tax income but instead taxes the value of a company’s ability to generate income.
Substance over Form
PPL Corporation argues that whether a foreign tax is considered a tax on “income,” “war profits,” or “excess profits” depends on the interpretation given by U.S. tax law and not by the tax law of the foreign country. PPL argues that in determining creditability (whether a tax meets one of the three categories just listed) of foreign taxes paid, U.S. tax law has always looked beyond the label or name of the tax imposed by the foreign country and instead focused on how the tax operates—the substance of the tax. Furthermore, the PPL notes that the Treasury Regulations, particularly § 1.901-2, suggest that a substance-based approach should be used: For example, the Treasury Regulations state that “income” includes any income that has already been earned, is revenue based on gross receipts, or is net income, which equals gross receipts minus expenditures. PPL asserts that Congress intended, as shown in § 901 of the I.R.C., that in such situations, the substance of a tax trumps its form because tax law aims to reach the realities of economic transactions and dealings. According to PPL, a court must examine the actual operation and effects of a tax to adhere to the legislative intent to shape tax law to the realities of business. To PPL, the formal wording of a foreign country’s tax law does not allow U.S. taxpayers and tax officials to fully understand the purpose and function of the U.S. tax laws. Although the windfall tax purports to tax the difference between two values, the tax actually targets profits in excess of the price for the company in the market. Moreover, PPL asserts that if U.S. tax credit is not provided for windfall taxes paid to the U.K. government, then the profits of American companies would be subject to the unfair practice of double taxation.
The Commissioner argues that the substance of the U.K. windfall tax is the same as the form or labels that the British tax authorities have provided. The Commissioner states that the windfall tax does in fact tax the difference between two values—a privatization value and a profit-making value. The Commissioner argues that the windfall tax simply uses total profits as an estimation of the values, or worth, of companies at the time of their offerings of fixed shares to the public. In other words, the Commissioner argues that the U.K. windfall tax is a tax on the value of a company in relation to how much the U.K. government would receive for the company if it were sold; in essence, the tax is meant to capture the ability of a company to generate income. The Commissioner argues that PPL inaccurately calculated and represented its mathematical theory that the windfall tax is a 51.75 percent tax on excess profits. On the contrary, the Commissioner claims that the U.K. windfall tax is a one-time tax of 23 percent on the difference between the privatization value and the profit-making value, but it is not a tax on profits or income. Put differently, the windfall amount that is taxed reflects the difference between the price at which a company should have sold its initial stocks and the price at which is actually sold. In response to PPL’s argument about double taxation, the Commissioner asserts that because the windfall tax is not an income tax, PPL’s profits are not actually taxed twice. According to the Commissioner, PPL had received a foreign tax credit so it cannot claim that it has been doubly taxed. Furthermore, the Commissioner notes that non-income taxes imposed by foreign jurisdictions receive tax deductions under a U.S. tax provision separate from those provisions dealing with income taxes; this non-income tax deduction is under 26 U.S.C. 164(a)(3).
Net Gain and the Calculation of the Windfall Tax
PPL contends that the U.K. windfall tax is a tax on income because the tax reaches the company’s net gain. PPL points to expert testimony explaining that the U.K. and U.S. tax systems are essentially the same: The U.K. windfall tax uses a company’s profits to calculate the amount of taxes due, and as such, the windfall tax is a tax that look at value of a company’s gross receipts, which is a form of income under U.S. tax regulations. Furthermore, PPL notes that the drafters of the U.K. windfall tax intended and planned to tax excess profits, but, due to the political and economic environment of the U.K. at the time, the drafters decided to disguise the windfall tax as the difference between two values in order to avoid recognition as an excess profits tax. PPL further claims that the foreign tax exhibits a direct link between tax liability and profits, and other windfall taxes, imposed by not only the U.K. but also the U.S., have been held creditable by the relevant government authorities and agencies.
Responding to the argument by PPL, the Commissioner states that under federal regulations, particularly 26 C.F.R. 1.901-2(b)(2)-(4), a foreign tax is likely to reach net gain if and only if it satisfies three regulatory tests—the realization test, the gross-receipts test, and the net-income test. The Commissioner claims that there was no realization of income when the U.K. government taxed PPL because a number of the companies that paid the windfall tax had to pay values greater than the total profits during an initial period. According to the Commissioner, this is due to the fact that PPL likely had some net gain remaining after paying the windfall tax. Furthermore, the Commissioner argues that the windfall tax does not satisfy the net-income test because the windfall tax is not a tax based on gross income or gross receipts. To the Commissioner, the value of the receipts went into a larger formula that produced a value of the company separate from gross receipts. Further, the Commissioner argues that the calculation of the windfall tax only uses gross income as a general inquiry—not a main consideration—into the amount of windfall tax owed. Thus, the Commissioner asserts that the U.K. windfall tax does not satisfy any of the three regulatory tests and is not a foreign tax that reaches net gain.
The Supreme Court’s decision in this case will determine whether a windfall tax involving gross receipts and excess profit constitutes the equivalent of a United States income tax and thus is eligible for a foreign tax credit under the Internal Revenue Code. Petitioner PPL argues that the windfall tax is an income tax, but Respondent Commissioner of Internal Revenue contends that the windfall tax is simply a one-time tax on the ability of a company to generate income. A holding for PPL may vex the coherence of the U.S. tax code while constricting power of the Commissioner of Internal Revenue to interpret the law. However, a holding for the Commissioner may allow the U.S. government to circumvent the legislative process to doubly tax companies in PPL’s position.
- Ilya Shapiro & Matt Gilliam, Cato Institute, PPL Corp. v. Commission of Internal Revenue (Dec. 20, 2012)
- The Oyez Project, PPL Corporation v. Commissioner of Internal Revenue (Jan. 18, 2013)
- Jonathan Stempel & Patrick Temple-West, Thomson Reuters News & Insight, Supreme Court Accepts PPL Appeal in British Tax Case (Oct. 29, 2012)