UK windfall profits tax eligible for US foreign tax credit, US Supreme Court holds

In a unanimous decision, the US Supreme Court held that the United Kingdom’s windfall profits tax imposed on newly privatised businesses was creditable against US taxes under Section 901 of the Internal Revenue Code (PPL Corp., No.12-43 (U.S. 5/20/13)). In doing so, the Court reversed the US Third Circuit Court of Appeals’ decision (665 F.3d 60 (3d Cir. 2011)) and, to a certain extent, adopted the reasoning of the Fifth Circuit in Entergy Corp., 683 F.3d 233 (5th Cir. 2012) (although that case was not before the Court).  

Background

Under Sec. 901(b)(1), taxpayers can claim a credit for “the amount of any income, war profits, and excess profits taxes paid or accrued . . . to any foreign country.” The regulation promulgated by the US Treasury Department to interpret Sec. 901   combines the statutory terms, “income, war profits, and excess profits tax,” into one concept: income tax. A foreign assessment is an income tax if it has the “predominant character . . . of an income tax in the U.S. sense” (Regs. Sec. 1.901-2(a)(1)(ii)).

A foreign assessment has the predominant character of a tax if it is “likely to reach net gain in the normal circumstances in which it applies.” An assessment is “likely to reach net gain” if it meets three requirements: the realisation, gross receipts, and net income requirements (Regs. Sec. 1.901-2(b)(1)). The realisation requirement provides that a taxpayer must have received the income before being obligated to pay taxes on it. The gross receipts and net income requirements concern the tax base, i.e., the amount on which the tax is levied.
 
Supreme Court decision

The unanimous decision, written by Justice Clarence Thomas (a concurring opinion was filed by Justice Sonia Sotomayor), stated that the UK windfall profits tax, which was imposed on companies after they were privatised, was not, as the British government claimed, a tax on the difference between the value at which the companies were sold and the value for which they should have been sold. The Court found that the way a foreign government characterises a tax has no bearing on the “U.S. creditability analysis” (slip op. at 5).

The Court then explained that the Third Circuit Court of Appeals had adopted the UK’s characterisation of the tax and, on that basis, found that the tax failed the gross receipts and realisation tests because it taxed some artificial valuation instead of profits (slip op. at 7). The taxpayer, however, emphasised that the tax was a tax on the actual profits earned by the company, no matter what the British government said.

The Court agreed with the taxpayer “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” and was therefore creditable (slip op. at 8). Thomas then engaged in a complicated mathematical reformulation of the tax to demonstrate that the tax was a tax on the profits actually earned. In response to the objection to the rearrangement of the UK tax formula by the Internal Revenue Service, the US tax agency, the Court emphasised that it was not bound by the UK’s characterisation, especially since the UK’s method of calculating the tax was artificial. Accordingly, the Court followed “substance over form and recognize[d] that the windfall tax is nothing more than a tax on actual profits above a threshold” (slip op. at 11).

—Sally P. Schreiber (sschreiber@aicpa.org) is a CGMA Magazine senior editor.