The Supreme Court of the United States recently granted certiorari to hear an appeal by PPL Corporation (PPL) regarding whether a so-called windfall profits tax paid by a subsidiary of PPL to the United Kingdom is creditable as a foreign income tax under IRC §901 for purposes of U.S. income tax. The Supreme Court granted certiorari premised on a direct conflict between decisions reached by two different U.S. courts of appeals on the same issue and nearly identical facts.
To alleviate the burden of double taxation, IRC §901 grants U.S. citizens and corporations an income tax credit for “the amount of any income, war profits and excess-profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States.” Historically, whether a foreign tax was creditable was judged based on U.S. tax law principles and not on the label ascribed by the foreign government that imposed the tax.
In two separate cases before the same judge, the U.S. Tax Court found in favor of the taxpayers, ruling that UK windfall profits tax was creditable as a foreign income tax. The Tax Court weighed hundreds of pages of expert reports and trial testimony in both cases. The Tax Court determined that the inquiry of whether a foreign tax is creditable for U.S. income tax purposes is based upon the “predominant standard for creditability” laid out in Treasury Regulation §1.901-2, which was first enacted in 1983. Under that approach, a foreign tax is an income tax “if and only if the tax, judged on the basis of its predominant character,” satisfies three tests. The foreign tax must be imposed on realized income (i.e., income that has already been earned), the basis of gross receipts (i.e., revenue) and net income (i.e., gross receipts less significant costs and expenditures). See Treas. Reg. §1.901-2(a)(3).
The Tax Court held that by “implicating the circumstances of application in the determination of the predominant character of a foreign tax, the drafters of the 1983 regulations clearly signaled their intent that factors extrinsic to the text of the foreign tax play a role in determining the tax’s character.” The Tax Court held that this approach was consistent with the case law that preceded the regulations. Lastly, the Tax Court looked at the practical effect that the U.K. windfall tax had on the companies that paid it, the circumstances of its adoption and the intent of the members of Parliament who enacted it, and concluded that the substance of the tax was to tax excess profits.
The Internal Revenue Service (IRS) appealed both decisions and venue lay in two different U.S. circuit courts of appeals. In PPL Corporation v. Commissioner, the U.S. Court of Appeals for the Third Circuit reversed the Tax Court, holding in favor of the IRS. In that case, the Third Circuit adopted the IRS’s formulaic approach for determining whether a foreign tax is creditable under U.S. law. The Third Circuit refused to consider the practical effect of the UK windfall tax and the intent of its drafters, and instead focused solely on the text of the tax statute, which in its estimation was a tax on excess value and not profits.
On the other hand, in Entergy Corporation v. Commissioner, the U.S. Court of Appeals for the Fifth Circuit affirmed the Tax Court and ruled in favor of the taxpayer. That court looked beyond the statute and reviewed the tax’s practical effect on the taxpayer. The court explained that Parliament’s decision to label an “entirely profit-driven figure a ‘profit-making value’ must not obscure the history and actual effect of the tax.” The Fifth Circuit openly acknowledged the circuit split with the Third Circuit’s PPL decision and rejected the Third Circuit’s reasoning as incorrectly “exemplifying the form-over-substance methodology that the governing regulation and case law eschew.”
In the PPL case, the Supreme Court will likely set forth the test of how U.S. taxpayers should determine whether a foreign tax is creditable for U.S. income tax purposes. Many tax professionals believe this case may have important implications for the role of substance over form in the context of tax law. This decision may have far-reaching ramifications for many U.S. taxpayers who routinely claim foreign tax credits.