Argument preview: Giving credit where credit is due

Allison Christians is the H. Heward Stikeman Chair in Tax Law, McGill University

On February 20, the Supreme Court will hear oral arguments in PPL Corp. and Subsidiaries v. Commissioner, in which it will consider how, and how well, Congress has defined rules under which the United States reduces tax on Americans who pay foreign taxes on income earned abroad. The case will have far-reaching consequences for Americans who earn foreign income: a decision in favor of PPL Corp would make for a more generous rule that could significantly reduce how much tax the U.S. collects on income earned abroad, while a decision upholding the court below would continue a more restrictive status quo.

Background

The “big picture” issue posed by PPL Corp. is how far countries ought to accommodate each other when their regulatory jurisdictions overlap. Such an overlap can occur easily when an American taxpayer earns income in a foreign country, because each government sees the income as a potential source of revenue. Thus an American who runs a business in a foreign country will be asked to pay tax first by the foreign country and again when she brings the money home to the United States. This potential for double taxation is considered an onerous drag on international trade and investment that benefits neither country, so governments have decided to “share” the income tax in some principled manner.

Most countries have opted to give the country in which the income arises – the source state – the first bite at the apple. That means that the investor’s home country – usually referred to as the residence state, and in PPL’s case the United States – should cede its right to collect tax on foreign-source income, so the taxpayer will only face a single tax. The mechanism for that is a foreign tax credit, which in the U.S. is found in the Internal Revenue Code § 901. As a residence state, the U.S. provides the § 901 credit, with various restrictions, for income taxes paid by Americans to source states. Other states have similar rules to credit their resident taxpayers for taxes paid to the United States.

This works out as a quid pro quo internationally only if each country gives credit where credit is due. That means that a state should only give a tax credit when the tax you credit as a residence state is effectively the same as the tax you collect when you are the source state. Otherwise the tax relieved goes beyond “double” tax, and one country will be giving up more revenue than the other.

In the United States, therefore, the rule for taking foreign tax credits is that the tax in question must be “creditable,” which, according to the statute, means “any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country.”

The regulations that accompany § 901 combine “income, war profits, and excess profits taxes” under the single term “income tax, and define that by means of two tests:

A foreign levy is an income tax if and only if—

(i) It is a tax; and

(ii) The predominant character of that tax is that of an income tax in the U.S. sense.

The latter standard is the one at issue in this case. The regulations provide that the predominant character standard is met “if the foreign tax is likely to reach net gain in the normal circumstances in which it applies.” Regulation § 1.901-2(b) further states that “a foreign tax is likely to reach net gain in the normal circumstances in which it applies if and only if the tax, judged on the basis of its predominant character, satisfies each of the realization, gross receipts, and net income requirements set forth in . . . this section.” To be creditable under § 901, a foreign tax must meet all three tests in the regulation. The parties’ arguments thus center on deciphering this provision as it applies to a foreign tax imposed on the respondent.

Accordingly, the case arises as a result of U.K. legislation enacting what was labeled a “windfall tax.” The legislation provides that:

Every company which, on 2nd July 1997, was benefitting from a windfall from the flotation of an undertaking whose privatisation involved the imposition of economic regulation shall be charged with a tax (to be known as the “windfall tax”) on the amount of that windfall.

(2)Windfall tax shall be charged at the rate of 23 per cent.

(3)Schedule 1 to this Act (which sets out how to quantify the windfall from which a company was benefitting on 2nd July 1997) shall have effect.

The “windfall” is defined as the difference between a company’s “profit-making value” and its “flotation value.” Profit-making value is defined as average annual profit per day over a specified period, multiplied by an imputed price-to-earnings ratio of nine.  Flotation value is defined as the price at which the company was privatized. Thus, importantly for both the petitioner and the respondent, the tax can be laid out algebraically in a formula:

Windfall Tax = 23% x (((365 x P/D) x 9) – FV).

Where P is the total profits for the company’s initial period, D is the number of days in the initial period, FV is the company’s flotation value, and 9 is a proxy for an industry-averaged price-to-earnings ratio. PPL argues that by rearranging the formula algebraically, it can be demonstrated that the tax in fact gets at income even though it appears formalistically to be directed at value.

Both parties argue that the arrangement of the formula matters because of what it reveals about the U.K.’s purpose in imposing this tax and therefore the character of the tax for U.S. purposes.  In brief, the tax arises as a clawback of sorts with respect to companies that bought national utilities enterprises when the U.K. government privatized them in 1979. At the time of privatization, the U.K. government also regulated the prices they could charge for the first four years, in an effort to provide an incentive for efficiency-increasing behavior by the private sector while also protecting consumers. But the companies reaped tremendous profits even under the price controls, and the public began to view the privatization as having been overly generous. This generosity came at a cost to the taxpaying public, which had either been short-changed in the pricing of the utilities at privatization (i.e., the flotation value was too low) or via excessively high pricing thereafter.

The Labour Party was especially critical of the perceived giveaway, and when it took control of the U.K. government in 1997, it asserted its prior vows to claw something back from the profiting companies via a windfall tax. The Labour Party promised to use the revenue from that tax to fund a £5 billion welfare-to-work youth employment training program. After much debate, including a rejection of a straightforward windfall tax calculated on actual profits, the Labour party settled on a twenty-three-percent tax calculated by reference to flotation value and profits realized in an initial period after privatization.

The question for the Supreme Court is whether this clawback windfall tax is in effect a retroactive tax on income earned by the companies over a roughly four-year period, or if on the contrary it is a mechanism to retroactively increase the price of the companies as of the time they were privatized. If the tax is the former, then it is equivalent to the kind of tax the U.S. would impose as a source state, and it should therefore be creditable. But if the tax is the latter, it is not the sort of tax that the United States would impose as a source based country, so it should not be creditable.

The decisions below

The petitioner in the case now before the Court, PPL Corp., was subject to the U.K. windfall tax, and sought to characterize it as an income tax for purposes of the § 901 credit. When the IRS initially rejected its efforts to claim the credit, PPL countered that the tax was in effect a tax on income because the formula assessed value by reference to profits.  Thus PPL argued that while the language of the statute was crafted around the term “value” for political reasons, the statute’s practical effect was to impose a 51.75% tax on “excess profits” that the targeted companies earned in a four-year period after they were privatized. The Commissioner of Internal Revenue countered that the windfall tax was a tax on the undervaluation of the companies at the time of privatization. Since a tax on value did not meet the realization, gross receipts, or net income requirements, the IRS argued that the windfall tax failed the predominant character test under the regulations and was not creditable.

The Tax Court rejected the Commissioner’s argument that the windfall tax was a tax based on value, accepted petitioner’s argument that the windfall tax could be reformulated as a 51.71% tax on a company’s profits during the initial period, and concluded that since the tax “did, in fact, ‘reach net gain,’” it was creditable under § 901. The court explained that “a foreign levy [can] be directed at net gain or income even though it is, by its terms, imposed squarely on the difference between two values.”

Although the Fifth Circuit agreed with the Tax Court’s analysis in a similar case brought by Entergy Corp., the Third Circuit disagreed and reversed. It found first that the Tax Court had incorrectly applied the  “predominant character” standard by not requiring the tax to satisfy each of the three tests “bas[ed] on its predominant character” in order to be creditable under § 901. The Court also rejected the petitioner’s attempted algebraic reformulation, stating that it would virtually eliminate any limitation on creditability since “[a]ny tax on a multiple of receipts or profits could satisfy the gross receipts requirement, because we could reduce the starting point of its tax base to 100% of gross receipts by imagining a higher tax rate.” Finally, the Court held that the windfall tax failed to satisfy the realization test, which requires that the foreign tax be “imposed [u]pon or subsequent to the occurrence of events . . .  that would result in the realization of income” under US law, moreover the tax failed to ensure that the companies “had actually realized the amount being taxed.”

Supreme Court proceedings

PPL Corp. filed a petition for certiorari, in which it framed the question for the Court’s review as “[w]hether, 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.”  The Court granted the petition on October 29, 2012.

In its brief on the merits, PPL Corp. argues that the IRS must look at substance, rather than form, to decide whether a foreign tax imposed on PPL by the United Kingdom is a windfall tax under U.S. tax law and therefore creditable against the company’s domestic income taxes pursuant to § 901.  PPL, supported by four amicus briefs, argues that a rearrangement of the algebraic formula reveals that the character of the foreign tax in question is really a tax on income in the U.S. sense.

The government frames the question slightly differently, as “[w]hether the windfall tax … is an income tax for which a foreign tax credit is allowed. The government and its supporting amici argue that an appropriate determination of this question requires an examination of both the form and the substance of the tax, that in form and substance the foreign tax in question is a tax on value and not income, and that courts cannot allow taxpayers to algebraically reconfigure a foreign tax in to make it appear more like an income tax for U.S. purposes.