Instances of the globalization of national economies are everywhere these days, and the tax implications for corporations are a big part of that great intertwining. A change in the political climate in a foreign country can thus affect the tax returns of a U.S. company.
In one recent legal decision, for instance, a U.S. court found that the U.K. Windfall Tax is not an “income tax” and hence can’t be claimed as a foreign tax credit by a U.S. utility.
In the case in question, PPL Corp., a U.S.-based utility and energy holding company, as of 1997 held a 25% stake in SWEB, a utility in the United Kingdom. SWEB was one of 32 U.K. companies subject to a one-time “windfall” tax. The tax emerged from a change in the political climate: a backlash against the privatization of British utilities and transit operators. 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 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” multiplied by 365. The statute imputed a price-to-earnings ratio of 9 for all companies.
SWEB paid the windfall tax, and PPL filed a claim for a refund seeking a foreign tax credit for its share of the tax paid. The IRS denied PPL’s claim for a refund; however, the U.S. Tax Court agreed with PPL. The service appealed the tax court’s decision and that holding was reversed on appeal late last year.
The Internal Revenue Code provides a 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.” Elsewhere, it provides that a foreign assessment is an “income tax” if it has “the predominant character” of an income tax in the U.S. sense.
Further, a foreign assessment has a “tax character” if it is “likely to reach net gain in the normal circumstances in which it applies.” It is likely to reach net gain if and only if the tax satisfies each of three requirements: the “realization requirement,” the “gross receipts requirement,” and the “net income requirement.”
The realization requirement is that the tax is imposed on or after the occurrence of events that would result in the realization of income under U.S. tax law. The gross receipts requirement is that the tax is imposed on gross receipts or an amount not greater than gross receipts. The net income requirement is that the taxpayer must deduct from gross receipts the costs and expenses incurred in earning those receipts.
The three requirements concern the timing and the “base” of the foreign tax, the difference between the company’s profit-making value and its flotation value. Neither value represents the company’s gross receipts, nor does the tax base account for recognizable costs and expenses. Thus, the IRS commissioner contended, the windfall tax fails to meet either the gross receipts or the net income requirement.
In PPL’s view, looking through the form of the tax to its substance reveals that the tax is, in substance, a tax on profits, specifically on excess profits. The court disagreed, contending that PPL’s formulation of the substance of the U.K. windfall tax “is a bridge too far.”
A tax, the court concluded, must satisfy the three requirements to be creditable. The U.K. tax fails to satisfy the gross receipts requirement. Therefore, the U.K. Windfall Tax is not creditable.
Robert Willens, founder and principal of Robert Willens LLC, writes a tax column for CFO.com.