On May 20, 2013, the Supreme Court decided PPL Corp. v. Commissioner, holding that a British “windfall tax” imposed on privatized British companies has the predominant character of an excess profits tax and is therefore creditable under Internal Revenue Code (IRC) Section 901.
The case revolved around one of PPL’s British subsidiaries which was subject to a one-time windfall tax in the United Kingdom. When PPL paid the British tax, it claimed a foreign tax credit pursuant to IRC Section 901(b)(1), which applies to “income, war profits, and excess profits.”
The issue, in this case, was 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 whether courts should employ a substance-based approach that considers factors such as the practical operation and intended effect of the foreign tax. The Tax Court found for PPL, but on appeal, the Third Circuit reversed.
In a fairly brief opinion, the Court surmised the government’s position as a formalistic approach in applying the tax law. The Court, on the other hand, stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.” The Court relied on the regulatory test which looks to “the normal manner in which a tax applies;” meaning that the Court would look at how the tax affects taxpayers in most instances, instead of looking at the impact of the tax on a handful of taxpayers.
Next, the Court stated that “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.” Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable. Alternatively, the Court found that the British formula relied on a fictitious value calculated using an imputed profit-to-earnings ratio.
Ultimately, the Court, through an algebraic reformulation of the equation used for computing the British tax, agreed with PPL’s argument that the British tax was the equivalent of a U.S. tax on excess profits tax. The Court declared that it must look at “economic realities, not legal abstractions.” In conclusion, the Court held that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.” Here, the tax was viewed by the Court as economically equivalent to the difference between what PPL actually earned and the amount the British government believed they should have earned given their respective floatation values. Those actual “excess profits” above the threshold were taxed at the prescribed British tax rate of 51.71 percent.
The PPL decision will have an immediate impact on the way courts determine the creditability of the foreign taxes; courts should look not to the way a foreign government characterizes tax at issue, but rather, they should look at the foreign tax as if it were a U.S. tax and analyze it accordingly.
To read the Court’s decision, click here.