The January 2012y posting below in blue provides the detail of the rejection for the foreign tax credit for the U.K. energy tax. This week a different Appeals Court ruled the opposite.
This post provide a June 2012 Appeals Court case with the opposite result. This case is in black print. Both the Tax Court and the Appeals Court ruled in favor of the taxpayer. But, what is a tax planner to do. You must follow the Appeals Court where your client resides. This means that we all do not have the same tax law. Your tax planner must read the cases decided in the part of the country where you live. The Fifth Circuit includes Texas (more on this link).
The Third Circuit includes New Jersey (more on this link).
In ENTERGY CORPORATION AND AFFILIATED SUBSIDIARIES, the Appeals Court allowed the taxpayer the foreign tax credit for a UK tax. If you live in Texas, this is the law. If you live in New Jersey, the law is the opposite.
For more information, contact Brian Dooley, CPA at 714-710-9122 or email Brian at firstname.lastname@example.org
Petitioner – Appellee v. COMMISSIONER OF INTERNAL REVENUE, Respondent – Appellant Docket No. 10-60988 Date of Decision: June 5, 2012 Judge: Jones, Edith H.
Section 901 — Foreign Tax Credit
IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT Appeal from a Decision of the United States Tax Court Before JONES, Chief Judge, and DAVIS and DeMOSS, Circuit Judges.
EDITH H. JONES, Chief Judge:
Appellant Commissioner of Internal Revenue (“Commissioner”) seeks review of a United States Tax Court decision favoring Appellee Entergy Corp. (“Entergy”) for the taxable years 1997 and 1998. By reference to a companion case, PPL Corp. v. Comm’r, 135 T.C. 304 (2010), rev’d, 665 F.3d 60 (3d Cir. 2011), the Tax Court concluded Entergy was entitled to a foreign income tax credit for its subsidiary’s payment of the United Kingdom’s Windfall Tax. The sole question on appeal is whether the Windfall Tax constitutes a creditable foreign income tax under I.R.C. § 901, 26 U.S.C. § 901. Notwithstanding the Third Circuit’s contrary opinion, we AFFIRM.
The Tax Court and parties treat PPL Corp. as materially identical to this case; we do so as well. See Entergy Corp. v. Comm’r, 100 T.C.M. (CCH) 202 (2010). The Tax Court and Third Circuit ably detail the history of the Windfall Tax, and we briefly summarize the relevant facts.
Entergy owns London Electricity, one of thirty-two companies, generally utilities, the U.K. privatized through the 1980s and 1990s. The U.K. government set price controls on these utilities but not caps on profits; the newly privatized corporations quickly reduced costs beyond governmental expectations, reaping higher-than-expected profits, share prices, and executive compensation. This in turn led to a public backlash.
In response, the then-opposition Labour Party proposed a new tax on the utilities — a “windfall levy on the excess profits of the privatised utilities.” Enlisting the accounting firm Arthur Andersen, the Labour Party designed a series of proposals, including gross receipts taxes and profits taxes, to recoup a desired proportion of the utilities’ profits. Geoffrey Robinson, a Labour Member of Parliament, and Gordon Brown, Shadow Chancellor of the Exchequer, ultimately selected the Windfall Tax. Once in power, the Labour Party passed the tax.
The Windfall Tax was designed to address the public’s concern that the utilities had been sold too cheaply in light of their profit potential. It imposed on each of the utilities a one-time 23% assessment on the difference between: (1) a company’s “profit-making value,” defined as its average annual profit per day over an initial period (typically, as here, four years) multiplied by 9, an imputed “price-to-earnings ratio,” and (2) its “flotation value,” or the price for which it was privatized.
London Electricity timely paid slightly less than £140M as a result of the Windfall Tax, and Entergy filed an amended US. federal tax return in 1998 claiming an equivalent credit — approximately $234M. When the IRS disallowed the credit in a notice of deficiency, Entergy contested the notice by filing a petition with the Tax Court. Entergy and the Commissioner essentially disagreed on whether the Windfall Tax — on “profit-making value,” calculated as explained above — constituted a tax on excess profits, creditable under I.R.C. § 901, or a tax on unrealized value for which Entergy could not claim a foreign income tax credit. Entergy demonstrated that the Windfall Tax could be mathematically re-expressed as a pure tax on profits; the Commissioner pointed to the statute’s reference to “profit-making value” as conclusively demonstrating that the tax reached unrealized value rather than excess profits.
The Tax Court relied on its parallel decision in PPL Corp. v. Comm’r, 135 T.C. 304 (2010), applying the relevant Treasury regulation interpreting Section 901, 26 C.F.R. § 1.901-2(a). Entergy, 100 T.C.M. (CCH) 202. The Tax Court determined the Windfall Tax was based on excess profits, and that it therefore necessarily satisfied § 1.901-2(a)’s three-part “predominant character” test: namely, that the Windfall Tax (1) reached only realized income, (2) was imposed on the basis of gross receipts, and (3) targeted only net income. PPL, 135 T.C. at 337-39. The Tax Court therefore ruled Entergy entitled to a tax credit. Entergy, 100 T.C.M. 202. The Commissioner appealed in both PPL and this case.
STANDARD OF REVIEW
This court applies the same standard of review to decisions of the Tax Court as we do to district court decisions: findings of fact are reviewed for clear error and issues of law are reviewed de novo. Terrell v. Comm’r, 625 F.3d 254, 258 (5th Cir. 2010).
The parties agree that 26 C.F.R. § 1.901-2(a) controls. It provides that “[a] foreign levy is an income tax if and only if[ ] . . . [t]he predominant character of that tax is an income tax in the U.S. sense.” 26 C.F.R. §§ 1.901-2(a)(1), (a)(1)(ii). A foreign tax’s predominant character “that tax is that of an income tax in the U.S. sense” if it “is likely to reach net gain in the normal circumstances in which it applies.” Id. at §§ (a)(3), (a)(3)(i). “A foreign tax is likely to reach net gain in the normal circumstances in which it applies if and only if the tax, judged on the basis of its predominant character, satisfies each of the realization, gross receipts, and net income requirements” established by the regulation. Id. at § 1.901-2(b)(1).
The realization requirement tracks the American income tax principle that income is typically taxed only following a “realization event,” usually “when property is sold or exchanged.” BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES & GIFTS ¶ 72.4.3 (2011). The gross income requirement mandates that “[g]enerally, the starting point for calculating income subject to a creditable foreign income tax must be actual gross receipts.” Id. And the net income requirement only allows accreditation for taxes which “provid[e] for ‘recovery of the significant costs and expenses (including significant capital expenditures) attributable, under reasonable principles, to [the] gross receipts included in the tax base.’” Id.
The Tax Court considered two competing interpretations of the Windfall
The Court of the Appeals for the Third Circuit reversed the Tax Court in ruling that the U.K. windfall profit tax is not eligible for the U.S. foreign tax credit law.
The United Kingdom has a windfall profits tax imposed on utilities. PPL Corporation & Subsidiaries has an utility operation in the U.K.
PPL is a Pennsylvania corporation. In 1997, it held a 25% stake in SWEB (formerly South Western Electricity Board), a utility in the United Kingdom. SWEB was one of 32 United Kingdom companies subject to a one-time “windfall tax.” After it paid that tax, PPL claimed under I.R.C. § 901 a foreign tax credit on its United States tax return. We must decide whether the U.K. windfall tax is an “income, war profits, [or] excess profits” tax within the meaning of § 901(b)(1).
The windfall tax emerged from a backlash against the privatization of British utilities and transit operators. The U.K.’s Government, then controlled by the Conservative Party, sold SWEB and 31 other state-owned companies to private investors between 1984 and 1996. Though privately owned, the utilities remained regulated. In particular, the U.K. Government set the rates at which the utilities would sell electricity to customers.
With the pricing scheme, it induced the new private owners to provide electricity more efficiently; every pound sterling that the owners could save would go to them as profit rather than to customers as lower prices. Most of the utilities, including SWEB, increased efficiency to a greater degree than the U.K. Government had expected. As a result, the utilities’ profits and their share prices increased. Executive compensation also increased, as it was tied in many cases to share prices. These high profits and compensation packages, coupled with the fixed costs that customers paid under the regulatory scheme, left the public unhappy with the utilities and their executives.
The opposition Labour Party sought to capitalize on this public discontent by introducing a new tax. Party leaders promised a “windfall levy on the excess profits of the privatised utilities,” in the words of Labour’s 1997 Election Manifesto. They put Geoffrey Robinson, a Labour Member of Parliament, in charge of the plan. He hired accounting firm Arthur Andersen to develop a series of proposals. Robinson and the Andersen team rejected simpler proposals, including taxes on gross receipts or on profits, and instead selected the “windfall tax” now at issue. Gordon Brown, then the Shadow Chancellor of the Exchequer, approved Robinson’s windfall tax proposal, and Parliament enacted it without substantive change after Labour won the 1997 elections.
In concept, the windfall tax was a one-time 23% tax on the difference between each company’s “profit-making value” and its “flotation value,” the price for which the U.K. Government had sold it. (The public believed that the Government had sold the companies too cheaply, hence the “windfall.”)
The tax statute defined each company’s “profit-making value” as its average annual profit multiplied by its price-to-earnings ratio. It defined average annual profit as the company’s average profit per day over a statutorily defined “initial period” (which for SWEB and most others was the first four years after privatization) multiplied by 365. Rather than using the companies’ actual price-to-earnings ratios, the statute imputed a ratio of 9 for all companies. This “ratio,” a U.K. Government document explained, “approximates to the lowest average sectoral price-to-earnings ratio of the companies liable to the tax.” J.A. at 264. We may express the tax algebraically in this way:
Tax = 23% x [(365 x (P/D) x 9) - FV ],
where 23% is the tax rate, P is the company’s total profit over the “initial period,” D is the length of the initial period in days, and FV is the company’s flotation value (to repeat, the price for which the U.K. Government sold the company).
SWEB paid the windfall tax, and PPL filed with the IRS a claim for refund seeking a foreign tax credit for PPL’s share of the windfall tax paid. In 2007, the IRS denied PPL’s claim for refund and issued a notice of deficiency. PPL then filed a petition in the Tax Court to challenge the IRS’s determination that it was not entitled to a credit under I.R.C. § 901 for PPL’s share of SWEB’s windfall tax.
The Tax Court held a trial and, after post-trial briefing and further testimony, agreed with PPL that it was entitled to a foreign tax credit. The Commissioner timely appealed to our Court, asserting that § 901 does not cover the windfall tax.
The Tax Court had jurisdiction under I.R.C. §§ 6213 and 6214, and our Court has jurisdiction under I.R.C. § 7482(a)(1). “We have plenary review over the Tax Court’s legal conclusions, and may set aside findings of fact if they are clearly erroneous.” Capital Blue Cross v. Comm’r, 431 F.3d 117, 123-24 (3d Cir. 2005).
While I believe that the Tax Court is a great court for cases involving complex law where it is clear that a tax shelter is not involved. Here the Tax Court properly interpreted the law. The law of the land (at least if you reside in the Third Circuit, and only the Third Circuit) is no FTC for the UK windfall profit tax.
Have a question, then please call me, Brian Dooley, CPA at 949-939-3414.