PPL Corp. v. Comm'r of Internal Revenue

In 1997, the United Kingdom (U.K.) imposed a one-time "windfall tax" on 32 U.K. companies privatized between 1984 and 1996. This case addresses whether that tax is creditable for U.S. tax purposes. Internal Revenue Code § 901(b)(1) states that any "income, war profits, and excess profits taxes" paid overseas are creditable against U.S. income taxes. 26 U.S.C. § 901 (b)(1). Treasury Regulations interpret 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." Treas. Reg. § 1.901-2 (a)(1)(ii), 26 C.F.R. § 1.901-2 (a)(1) (1992). Consistent with precedent and the Tax Court's analysis below, we apply the predominant character test using a commonsense approach

The U.K.'s Labour Party, which had unsuccessfully opposed privatization, used the companies' profitability as a campaign issue against the Conservative Party. In part because of campaign promises to tax what it characterized as undue profits, the Labour Party defeated the Conservative Party at the polls in 1997. Prior to coming to power, Labour Party leaders hired accounting firm Arthur Andersen to structure a tax that would capture excess, or "windfall," profits earned during the initial years in which the companies were prohibited from increasing rates. Parliament eventually adopted the tax, which applied only to the regulated companies that were prohibited from raising their rates. See Finance (No. 2) Act, 1997, ch. 58, pt. I, cls. 1 and 2(5) (Eng.) (U.K. Windfall Tax Act). It imposed a 23 percent tax on any "windfall" earned by such companies. Id., cl. 1(2). A separate schedule "se[t] out how to quantify the windfall from which a company was benefitting." Id., cl. 1(3). See id., sched. 1.

In the proceedings below, the parties stipulated that the following formula summarizes the tax imposed by the Labour Party:

P Tax = 23% [(365 × (-) × 9) - FV] D

D equals the number of days a company was subject to rate regulation (also known as the "initial period"), P equals the

The Third Circuit, following the Commissioner's lead, believed it could look no further than the tax formula that the Parliament enacted and the way in which the Labour government characterized it. Under that view, the windfall tax must be considered a tax on the difference between a company's flotation value (the total amount investors paid for the company when the government sold it) and an imputed "profit-making value," defined as a company's "average annual profit during its 'initial period' ... times 9, the assumed price-to-earnings ratio." 665 F.3d, at 65 . So characterized, the tax captures a portion of the difference between the price at which each company was sold and the price at which the Labour government believed each company should have been sold given the actual profits earned during the initial period. Relying on this characterization, the Third Circuit believed the windfall tax failed at least the Treasury Regulation's realization and gross receipts tests because it reached some artificial form of valuation instead of profits. See id., at 67 , and n. 3.

In contrast, PPL's position is that the substance of the windfall tax is that of an income tax in the U.S. sense. While recognizing that the tax ostensibly is based on the difference between two values, it argues that every "variable" in the windfall tax formula except for profits and flotation value is fixed (at least with regard to 27 of the 32 companies). PPL emphasizes that the only way the Labour government was able to calculate the imputed "profit-making value" at which it claimed companies should have been privatized was by looking after the fact at the actual profits

We agree with PPL and conclude that the predominant character of the windfall tax is that of an excess profits tax, a category of income tax in the U.S. sense. It is important to note that the Labour government's conception of "profit-making value" as a backward-looking analysis of historic profits is not a recognized valuation method; instead, it is a fictitious value calculated using an imputed price-to-earnings ratio. At trial, one of PPL's expert witnesses explained that " '9 is not an accurate P/E multiple, and it is not applied to current or expected future earnings.' " 135 T. C., at 326, n. 17 (quoting testimony). Instead, the windfall tax is a tax on realized net income disguised as a tax on the difference between two values, one of which is completely fictitious. See App. 251, Report ¶ 1.7 ("[T]he value in profit making terms described in the wording of the act ... is not a real value: it is rather a construct based on realised profits that would not have been known at the date of privatisation").

The substance of the windfall tax confirms the accuracy of this observation. As already noted, the parties stipulated that

(365 × 9 × 23%) 1,461 Tax = [---------------] × {P - [FV × ---------]} 1,461 (365 × 9)

Simplifying the formula by multiplying and dividing numbers reduces the formula to:

FV Tax = 51.71% × [P - (--) × 4.0027] 9

As noted, FV represents the value at which each company was privatized. FV is then divided by 9, the arbitrary "price-to-earnings ratio" applied to every company. The economic effect is to convert flotation value into the profits a company should have earned given the assumed price-to-earnings ratio. See 135 T. C., at 327 (" 'In effect, the way the tax works is to say that the amount of profits you're allowed in any year before you're subject to tax is equal to one-ninth of the flotation price. After that, profits are deemed excess, and there is a tax' " (quoting testimony from the treasurer of South Western Electricity plc)). The annual profits are then multiplied by 4.0027, giving the total "acceptable" profits (as opposed to windfall

The rearranged tax 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 the 27 companies that had 1,461-day initial periods, the U.K. tax formula's substantive effect was to impose a 51.71 percent tax on all profits earned above a threshold. That is a classic excess profits tax. See, e.g., Act of Mar. 3, 1917, ch. 159, Tit. II, § 201, 39 Stat. 1000 (8 percent tax imposed on excess profits exceeding the sum of $5,000 plus 8 percent of invested capital).

Of course, other algebraic reformulations of the windfall tax equation are possible. See 665 F.3d, at 66 ; Brief for Anne Alstott et al. as Amici Curiae 21-23 (Alstott Brief). The point of the reformulation is not that it yields a particular percentage (51.75 percent for most of the companies). Rather, the algebraic reformulations illustrate the economic substance of the tax and its interrelationship with net income.

The Commissioner argues that any algebraic rearrangement is improper, asserting that U.S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt. Brief for Respondent 28. As a result, the Commissioner claims that the analysis begins and ends with the Labour government's choice to characterize its tax base as the difference between "profit-making value" and flotation value. Such a rigid construction is unwarranted. It 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, 76 S.Ct. 395 , 100 L.Ed. 347 (1956). Given the artificiality of the U.K.'s method of calculating purported "value," we follow substance over form and recognize that the windfall tax

B

We find the Commissioner's other arguments unpersuasive as well. First, the Commissioner attempts to buttress the argument that the windfall tax is a tax on value by noting that some U.S. gift and estate taxes use actual, past profits to estimate value. Brief for Respondent 17-18 (citing 26 C.F.R. § 20.2031-3 (2012) and 26 U.S.C. § 2032A ). This argument misses the point. In the case of valuation for gift and estate taxes, past income may be used to estimate future income streams. But, it is future revenue-earning potential, reduced to market value, that is subject to taxation. The windfall profits tax, by contrast, undisputedly taxed past, realized net income alone.

The Commissioner contends that the U.K. was not trying to establish valuation as of the 1997 date on which the windfall tax was enacted but instead was attempting to derive a proper flotation valuation as of each company's flotation date. Brief for Respondent 21. The Commissioner asserts that there was no need to estimate future income (as in the case of the gift or estate recipient) because actual revenue numbers for the privatized companies were available. Ibid. That argument also misses the mark. It is true, of course, that the companies might have been privatized at higher flotation values had the government recognized how efficient-and

The Third Circuit believed that the same type of algebraic rearrangement used above could also be used to rearrange a tax imposed on Example 3. It hypothesized:

"Say that the tax rate on the hypothetical extraction tax is 20%. It is true that a 20% tax on 105% of receipts is mathematically equivalent to a 21% tax on 100% of receipts, the latter of which would satisfy the gross receipts requirement. PPL proposes that we make the same move here, increasing the tax rate from 23% to 51.75% so that there is no multiple of receipts in the tax base. But if the regulation allowed us to do that, the example would be a nullity. Any tax on a multiple of receipts or profits could satisfy the gross receipts requirement, because we could reduce the starting point of its tax base to 100% of gross receipts by imagining a higher tax rate." 665 F.3d, at 67 .

The Commissioner reiterates the Third Circuit's argument. Brief for Respondent 37-38.

There are three basic problems with this approach. As the Fifth Circuit correctly recognized, there is a difference between imputed and actual receipts. "Example 3 hypothesizes a tax on the extraction of petroleum where the income value of the petroleum is deemed to be ... deliberately greater than actual gross receipts." Entergy Corp., 683 F.3d, at 238 . In contrast, the windfall tax depends on actual figures. Ibid. ("There was no need to calculate imputed gross receipts; gross receipts were actually known"). Example 3 simply addresses a different foreign taxation issue.

The judgment of the Third Circuit is reversed.

It is so ordered.

The Court's conclusion that the windfall tax is a creditable excess profits tax under 26 U.S.C. § 901 (b)(1) depends on two interrelated analytic moves: first, restricting the "predominant character" analysis to those companies that shared an "initial period" of rate regulation of 1,461 days; and second, treating the tax's initial period variable as fixed. See ante, at 1903 - 1905. But there is a different way of looking at this case. If the predominant character inquiry is expanded to include the five companies that had different initial periods, especially those with much shorter initial periods, it becomes impossible to rewrite the windfall tax as an excess profits tax. Instead, it becomes clear that the windfall tax is functionally a tax on value. But because the Government took the position at oral argument that the predominant character inquiry should disregard such "outlie[r]" companies, see Tr. of Oral Arg. 38-39, and this argument is therefore only pressed by amici, Brief for Anne Alstott et al. as Amici Curiae 28-30 (hereinafter Alstott Brief), I reserve consideration of this argument for another day and another context and join the Court's opinion.

* * *

The Internal Revenue Code provides that "income, war profits, and excess profits taxes" paid to a foreign country

Importantly, though, the relevant Treasury Regulations also provide that a foreign tax "is or is not an income tax, in its entirety, for all persons subject to the tax." 26 C.F.R. § 1.901-2 (a)(1). One way to

P Tax = 23% × [(365 × (-) × 9) - FV ] D

If the predominant character analysis is restricted to those 27 companies that share an identical initial period length, then it makes sense to fix D at 1,461, as the Court does. Ante, at 1903 - 1905. And from there, it is just a matter of basic algebra, ante, at 1903 - 1904, and n. 4, to show that these companies' tax liability is equal to total profits minus a threshold amount (in this case, 44.47% of each company's flotation value) multiplied by a percentage-form tax rate: Tax = 51.71% x [ P − (44.47% x FV ) ]. See ante, at 1903 - 1904; Brief for Petitioners 10. Because an excess profits tax is generally a tax levied on the profits of a business beyond a particular threshold, see Wells, Legislative History of Excess Profits Taxation in the United States in World Wars I and II, 4 Nat. Tax J. 237, 243 (1951), it appears to follow that the windfall tax can properly be characterized as an excess profits tax.

But not all of the 32 affected companies had an initial period length of 1,461 days; 5 of the companies had different initial periods. See App. 34, 39-41. When these different initial period values are inserted into the formulation proposed by PPL, two results follow. First, these companies

This argument, however, rests on the premise that because the relevant regulations state that "a tax either is or is not an income tax, in its entirety, for all persons subject to the tax," 26 C.F.R. § 1.901-2 (a)(1)(ii), a tax's predominant character must be as an income tax for all taxpayers. But if a tax only needs to be an income tax for "a substantial number of taxpayers" and does not have to "satisfy the predominant character test in its application to all taxpayers," Exxon Corp. v. Commissioner, 113 T.C. 338 , 352 (1999), then this average profits argument cannot get off the ground. Under this reading, the regulations tell courts to treat outliers like Railtrack Group as flukes.

At oral argument, the Government apparently rejected the notion that "outliers" like Railtrack Group are relevant to creditability analysis. See Tr. of Oral Arg. 35-39. The Government also did not argue these outliers' relevance before the Court of Appeals, ante, at 1907, n. 6, and so this argument, and the regulatory interpretation it depends upon, has only been presented to this Court by amici, see Alstott Brief 17-18, 28-30. We are not barred from considering statutory and regulatory interpretations raised in an amicus brief, but we should be "reluctant to do so," Davis v. United States, 512 U.S. 452 , 457, n. *, 114 S.Ct. 2350 , 129 L.Ed.2d 362 (1994), when the issue is one of first

A

During the 1980's and 1990's, the U.K.'s Conservative Party controlled Parliament and privatized a number of

B

Petitioner PPL Corporation (PPL) was an owner, through a number of subsidiaries, of 25 percent of South Western Electricity plc, 1 of 12 government-owned electric companies that were privatized in 1990 and that were subject to the

Second, the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis. See § 1.901-2(a)(1)(ii) (foreign tax creditable if predominantly "an income tax in the U.S. sense"). In Biddle, the Court considered the creditability of certain U.K. taxes on stock dividends under the substantively identical predecessor to § 901. The Court recognized that "there is nothing in [the statute's] language to suggest that in allowing the credit for foreign tax payments, a shifting standard was adopted by reference to foreign characterizations and classifications of tax legislation." 302 U.S., at 578-579 , 58 S.Ct. 379 . See also United States v. Goodyear Tire & Rubber Co., 493 U.S. 132 , 145, 110 S.Ct. 462 , 107 L.Ed.2d 449 (1989) (noting in interpreting 26 U.S.C. § 902 that Biddle is particularly applicable "where a contrary interpretation would leave" tax interpretation "to the varying tax policies of foreign tax authorities"); Heiner v. Mellon, 304 U.S. 271 , 279, and n. 7, 58 S.Ct. 926 , 82 L.Ed. 1337 (1938) (state-law definitions generally not controlling in federal tax context). Instead of the foreign government's characterization of the tax, the crucial inquiry is the tax's economic effect. See Biddle,supra, at 579, 58 S.Ct. 379 (inquiry is "whether [a tax] is the substantial equivalent of payment of the tax as those terms are used in our own statute"). In other words, foreign tax creditability depends on whether the tax, if enacted in the U.S., would be an income, war profits, or excess profits tax.

Giving further form to these principles, Treasury Regulation § 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

The Commissioner's reliance on Example 3 to the Treasury Regulation's gross receipts test is also misplaced. Id., at 37-38 ; 26 C.F.R. § 1.901-2 (b)(3)(ii), Ex. 3. That example posits a petroleum tax in which "gross receipts from extraction income