Allison Christians is the H. Heward Stikeman Chair in Tax Law, McGill University
Employing what Justice Thomas calls a “commonsense approach,” yesterday the Court unanimously decided in favor of the taxpayer with respect to the creditability of a foreign tax in PPL Corp & Subsidiaries v. Commissioner.
Opinion author in red.
The Court held that PPL Corp., a U.S. company that owned a large interest in a U.K. energy company, is allowed to credit against its U.S. income tax an amount paid as a “windfall tax” to the U.K. government in 1997. The ruling reverses the judgment of the U.S. Court of Appeals for the Third Circuit, and sides instead with the Tax Court and the decision of the U.S. Court of Appeals for the Fifth Circuit in Entergy Corp. & Affiliated Subsidiaries v. Commissioner,.
The case settles a circuit split but leaves unresolved some fundamental questions about how the United States ought to decide whether amounts paid by Americans to foreign governments qualify as a tax on income, war profits, or excess profits. When they do so qualify, such payments are eligible for credit against U.S. income taxes. Justice Thomas wrote for the Court, while Justice Sotomayor filed a concurring opinion to make a few points about one such unresolved question.
Justice Thomas opens the Court’s opinion with a recitation of the social and political context that created the tax in question; namely, the privatization of certain energy companies by a conservative U.K. government, followed by a redetermination of the privatization price by a subsequent government formed by the U.K. Labour Party. Justice Thomas observes that:
As part of privatization, many companies were required to continue providing services at the same rates they had offered under government control for a fixed period, typically their first four years of private operation. As a result, the companies could only increase profits during this period by operating more efficiently. Responding to market incentives, many of the companies became dramatically more efficient and earned substantial profits in the process.
Having thus established that the base of the tax in question was the outsize profits unexpectedly earned through efficient business practices, Justice Thomas makes two observations to clarify the foreign tax creditability jurisprudence before concluding that the tax imposed by the Labour Party was ultimately a tax on income and therefore creditable. Both observations turn on the interpretation of the foundational rule set forth in Treasury regulations, which states that a foreign tax is an income tax “if and only if . . . [t]he predominant character of that tax is that of an income tax in the U.S. sense.”
In his first observation, Justice Thomas introduces a twist in the habitual presentation of the last clause of that phrase; namely, “in the U.S. sense.” He explains that this clause means that “foreign tax creditability depends on whether the tax, if enacted in the U.S., would be an income, war profits, or excess profits tax.” The words “if enacted in the U.S.” represent a small deviation from past jurisprudence, which simply repeats verbatim the regulatory language before going on to discuss the longstanding doctrine starting with Biddle v. Commissioner, as Justice Thomas does. The deviation may be inconsequential: perhaps there is no effective difference between a tax that is an income tax “in the U.S. sense” and one that would be an income tax “if enacted in the U.S.” But as every law student knows, precedent has been made on the strength of a comma, so it may be that this interpretive change is not, upon reflection, altogether inconsequential.
In the second observation, Justice Thomas adopts an implicitly expansive reading of the first words of that same regulatory definition, namely the “predominant character” of the tax. He explains that “predominant character” means “the normal manner in which a tax applies,” so a tax can be an income tax even if it does not affect all taxpayers in the same way. This accords with PPL Corp.’s position at oral argument, where it posited that the predominant character analysis may ignore “anomalous” situations and find a tax to be an income tax if in most cases it acts as such. Justice Thomas concludes that “[c]reditability is an all or nothing proposition,” citing the regulatory explanation that “a tax either is or is not an income tax, in its entirety, for all persons subject to the tax.”
This second observation is likely to garner much attention in commentary going forward, as it implicitly, and without much explanation, rejects the interpretive approach taken by amici in the brief submitted by a group of tax law professors, led by Professor Anne Alstott. The professors had argued that the opposite meaning should be derived from the regulatory language: that is, a tax should not be viewed as an income tax unless it acts as an income tax with respect to all taxpayers to which it applies. Since the reformulated equation would have imposed a tax on one of the energy companies at a rate of more than twice its profit, the professors argued that the tax would not target a net gain and therefore could not be an income tax under an “all or nothing” interpretation. In other words, the amici argued that the “outliers” for whom a tax would not act as an income tax should not be ignored in making a predominant character analysis but rather should be central to such an analysis.
Justice Sotomayor’s opinion (and perhaps Justice Kagan’s lack of an opinion, given her apparent disagreement with PPL Corp.’s position on the outlier issue at oral argument) will fuel ongoing discussion about the Court’s rejection of this argument, as it takes on this observation more directly than that by Justice Thomas. Justice Sotomayor points to the government’s failure to address the outlier argument as a reason for voting with the other members of the Court. Her analysis tracks the professors’ amici brief, which points out that the Tax Court effectively “wrote [the all or nothing] requirement out of the regulations” because the Commissioner “failed to insist upon it in a prior Tax Court proceeding . . . ..” Justice Sotomayor clearly found the amici’s argument compelling (and she had appeared unsympathetic to PPL Corp. at oral argument) but noted that the Court should be reluctant to consider interpretations raised by amici, especially when “the issue is one of first impression and the Federal Government has staked out what appears to be a contrary position.” This appears to leave room for a future foreign tax credit case to deal with the “outlier” problem more directly.
The present case, however, takes a much simpler approach. After surveying the jurisprudence that touches the applicable regulatory language, Justice Thomas makes fairly short work of the decision. He distills the various tests to their essence: “A foreign tax that reaches net income, or profits, is creditable.”
From there, the opinion adopts the algebraic reformulations that were suggested by PPL Corp. and accepted by the Tax Court, and finds that, reformulated, the tax looks like a 51.57% tax on excess profits, as urged by PPL Corp. and supporting amici. In her concurrence, Justice Sotomayor points out that certain of the base assumptions that drove such reformulations were not, in fact, true to reality, but given the government’s acquiescence in the reformulation exercise, she finds no reason to search for an alternative conclusion.
Justice Thomas thus concludes determinatively:
The economic substance of the U. K. windfall tax is that of a U. S. income tax. The tax is based on net income, and the fact that the Labour government chose to characterize it as a tax on the difference between two values is not dispositive under Treasury Regulation §1.901–2. Therefore, the tax is creditable under §901.
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