PPL Corp. v. Commissioner of Internal Revenue, No. 12-43; U.S. Supreme Court; opinion by Thomas, J.; concurrence by Sotomayor, J.; decided May 20, 2013. On certiorari to the U.S. Court of Appeals for the Third Circuit.
In 1997, the United Kingdom (U.K.), newly under Labour Party rule, imposed a one-time "windfall tax" on 32 U.K. companies privatized between 1984 and 1996 by the Conservative government. The companies had been sold to private parties through an initial sale of shares, known as a "flotation." Some of the companies were required to continue providing services for a fixed period at the same rates they had offered under government control. Many of those companies became dramatically more efficient and earned substantial profits in the process.
Petitioner PPL Corporation (PPL), part owner of a privatized U.K. company subject to the windfall tax, claimed a credit for its share of the bill in its 1997 federal income-tax return, relying on Internal Revenue Code § 901(b)(1), which states that any "income, war profits, and excess profits taxes" paid overseas are creditable against U.S. income taxes. Treasury Regulation § 1.901-2(a)(1) interprets this section to mean that a foreign tax is creditable if its "predominant character" "is that of an income tax in the U.S. sense." The commissioner of Internal Revenue Service rejected PPL’s claim, but the Tax Court held that the U.K. windfall tax was creditable for U.S. tax purposes under § 901. The Third Circuit reversed.
Held: The U.K. tax is creditable under § 901. Pp. 4-14.
(a) Treasury Regulation § 1.901-2, which codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938), provides the relevant legal standard. First, a tax’s "predominant character," or the normal manner in which a tax applies, is controlling. See id. at 579. Thus, a foreign tax that operates as an income, war profits or excess profits tax for most taxpayers is generally creditable. Second, foreign tax creditability depends not on the way a foreign government characterizes its tax but on whether the tax, if enacted in the U.S., would be an income, war profits or excess profits tax. See § 1.901-2(a)(1)(ii). Giving further form to these principles, § 1.901-2(a)(3)(i) explains that a foreign tax’s predominant character is that of a U.S. income tax "[i]f … the foreign tax is likely to reach net gain in the normal circumstances in which it applies." Three tests set forth in the regulations provide guidance in making this assessment, see § 1.901-2(b)(1). The tests indicate that net gain consists of realized gross receipts reduced by significant costs and expenses attributable to such gross receipts, in combination known as net income. A foreign tax that reaches net income, or profits, is creditable. Pp. 4-7.
(b) The U.K. windfall tax’s predominant character is that of an excess profits tax, a category of income tax in the U.S. sense. The Labour government’s conception of "profit-making value" as a backward-looking analysis of historic profits is not a typical valuation method. Rather, it is a tax on realized net income disguised as a tax on the difference between two values, one of which is a fictitious value calculated using an imputed price-to-earnings ratio. The substance of the windfall tax confirms this conclusion. When rearranged, the U.K.’s formula demonstrates that the windfall tax is economically equivalent to the difference between the profits each company actually earned and the amount the Labour government believed it should have earned given its flotation value. For most of the relevant companies, the U.K. formula’s substantive effect was to impose a 51.71 percent tax on all profits above a threshold, a classic excess profits tax. The commissioner claims that any algebraic rearrangement is improper because U.S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt. But such a rigid construction cannot be squared with the black-letter principle that "tax law deals in economic realities, not legal abstractions." Commissioner v. Southwest Exploration Co., 350 U.S. 308, 315. Given the artificiality of the U.K.’s calculation method, this court follows substance over form and recognizes that the windfall tax is nothing more than a tax on actual profits above a threshold. Pp. 7-11.
(c) The commissioner’s additional arguments in support of his position are similarly unpersuasive. Pp. 11-14.
665 F.3d 60, reversed.