Tax Law--U.K. Windfall Tax Constitutes U.S. Income Tax Under I.R.C. [section] 901(b)(1)--PPL Corp. v. Commissioner, 133 s. Ct. 1897 (2013)
The U.S. tax code allows citizens and domestic corporations to credit foreign taxes paid against U.S. taxes owed. (1) A foreign tax paid by a U.S. citizen or a domestic corporation may be creditable against domestic taxes when such tax is considered a levy on income. (2) Although the tax's "predominant character" controls in determining whether it is an income tax, the effect of a foreign country's characterization of the tax on such analysis has remained unsettled. (3) In PPL Corp. v. Commissioner, (4) the Supreme Court considered whether a windfall tax paid in the United Kingdom (U.K.), and characterized by the U.K. as a tax on value and not a tax on income, is creditable in the United States. (5) The Court held that the tax formula adopted by the U.K. Labour Party was an income tax in the United States for credit purposes bec ause the economic reality of the levy was a tax on the company's income. (6)
A Conservative Party-controlled British Parliament privatized certain government-owned companies in the 1980s and 1990s through an initial sale to the public known as a "flotation." (7) Petitioner PPL Corporation (PPL) was a U.S. company that owned twenty-five percent of one of the privatized companies, South Western Electricity plc (SWE). (8) For the four years after privatization, the British government required certain companies, including SWE, to charge customers the same rates they had charged under the government's control. (9) The companies became much more efficient during this period and earned large profits. (10)
In 1997, the Labour Party imposed a tax on those companies previously prohibited from raising their rates by hiring an accounting firm, Arthur Andersen, to structure a levy that would tax, at twenty-three percent, the windfall profits that the companies earned during the years in which they charged the required fixed rate. (11) In 1997, PPL claimed a U.S. tax credit under I.R.C. [section] 27(a) for the amount it paid under the windfall tax as a shareholder in SWE. (12) The Commissioner of Internal Revenue rejected PPL's credit claim, but the Tax Court found that the windfall tax was creditable. (13) On appeal, the United States Court of Appeals for the Third Circuit held that the tax was not creditable. (14)
Congress created the foreign tax credit (FTC)--defined in I.R.C. [section] 901 and allowed pursuant to I.R.C. [section] 27(a)--under the Revenue Act of 1918 "to mitigate the evil of double taxation." (15) Congress also intended the FTC to encourage foreign investment by Americans. (16) Under I.R.C. [section] 901(b)(1), a U.S. corporation may credit, dollar-for-dollar to their U.S. taxes, "the amount of any income ... and excess profits taxes paid or accrued ... to any foreign country." (17) Despite the statute's succinct language, the rules and interpretations involving FTCs have become fairly complicated and intricate over the past century. (18) The term "income" as used in I.R.C. [section] 901(b)(1) became a particular point of confusion for many courts. (19)
Part of the source of this confusion comes from the 1938 landmark Supreme Court case of Biddle v. Commissioner, in which the Court considered whether England's interpretation of a tax determined how the United States should interpret it for FTC purposes. (20) The Court provided the foundation for what would later be codified at section 1.901-1 of the Treasury Regulations by holding that U.S. tax law principles determine whether a tax is considered an income tax, and that a foreign country's interpretation of a tax is, at most, a factor among others that should be considered in the analysis. (21) Under section 1.901-1, when determining whether a foreign tax resembles a U.S. income tax, courts now analyze the foreign levy according to the predominant-character test, set forth in section 1.901-2 of the Treasury Regulations. (22) Under this test, and in line with the general principle of tax law, courts defer to the substance of a foreign levy over its form. (23) The predominant-character test is satisfied when a foreign tax is "likely to reach net gain in the normal circumstances in which it applies."
With the goal of avoiding uncertainty for businesses, courts have not allowed a foreign country's interpretation of a tax to carry their analysis of whether such tax was creditable. (25) The Supreme Court expressed its sensitivity to the problem of uncertainty early on when it acknowledged in Biddle that "there is nothing in [the statute's] 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." (26) Because courts "look first to the law of the foreign state in order to determine the nature of the obligations and rights which form the basis of the claim of a foreign tax credit," companies are required to be aware of both the foreign country's characterization of the tax and the United States' characterization of the tax, both of which may be unclear. (27) One challenge for businesses is that the "[f]ormalistic dependence of the [foreign tax] credit on legal liability can result in uncertainty because foreign law regarding legal liability is sometimes unclear." (28) Additionally, the uncertainty of foreign taxes can have a significant effect on foreign investment. (29)
In PPL Corp. v. Commissioner, the Supreme Court followed the long-standing tax principle of substance over form. The Court reasoned that Treasury Regulation [section] 1.901-2 establishes the principles relevant to the issue of whether a foreign tax is creditable against U.S. taxes, and that the predominant-character test applied. (31) Under the predominant-character test, the Court first determined that the U.K.'s windfall-tax formula included net income as a variable because it took a company's profit into account. (32) The Court agreed with PPL and the Fifth Circuit, deciding that the profits and floatation values were not fixed, and the only way to calculate the profit-making value was to consider the...