" [a]ny tax on a multiple of receipts or profits"
How later courts described this case
- " [a]ny tax on a multiple of receipts or profits"
Written by the judges who cited it.
The opinion
PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
_______________
No. 11-1069
_______________
PPL CORPORATION AND SUBSIDIARIES
v.
COMMISSIONER OF INTERNAL REVENUE
Appellant
_______________
Appeal from the Decision of the
United States Tax Court
Docket No. 07-25393
Tax Court Judge: Honorable James S. Halpern
_______________
Argued September 22, 2011
_______________
Before: AMBRO, CHAGARES and
*GARTH, Circuit Judges
(Opinion filed : December 22, 2011)
* Participated in Video Conference
Thomas J. Clark, Esquire
Gilbert S. Rothenberg, Esquire
Francesca U. Tamami, Esquire (Argued)
United States Department of Justice
Tax Division
950 Pennsylvania Avenue, N.W.
P.O. Box 502
Washington, DC 20044
Counsel for Appellant
Mark B. Bierbower, Esquire
Timothy L. Jacobs, Esquire
Richard E. May, Esquire (Argued)
Hunton & Williams LLP
2200 Pennsylvania Avenue, N.W.
Washington, DC 20037
Counsel for Appellee
Alan I. Horowitz, Esquire
Miller & Chevalier Chartered
655 Fifteenth Street, N.W., Suite 900
Washington, DC 20005
Counsel for Amicus Appellee
_______________
OPINION OF THE COURT
_______________
2
AMBRO, Circuit Judge
The Commissioner of Internal Revenue appeals a
decision of the United States Tax Court holding that PPL
Corporation was entitled to a foreign tax credit for the 1997
tax year under § 901 of the Internal Revenue Code. We agree
with the Commissioner that the foreign tax before us does not
qualify for a foreign tax credit, and thus reverse.
I. Background
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
3
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
4
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).
II. Discussion
A. The Applicable Test
To determine whether the U.K. windfall tax is a
creditable foreign tax, we start with I.R.C. § 901(b)(1). That
subsection provides a tax credit for “the amount of any
income, war profits, and excess profits taxes paid or accrued
5
during the taxable year to any foreign country.” Congress
first enacted these words in 1918, and it has not changed them
since. See Phillips Petroleum Co. v. Comm’r, 104 T.C. 256,
284 (1995) (discussing legislative history). In the decades
that followed, “the word ‘income’ in section 901(b)(1)
[became] the subject of a long and tortuous history” in case
law that was “permeated” with “vagaries, confusion, and
seeming contradictions.” Bank of Am. Nat’l Trust & Sav.
Ass’n v. Comm’r, 61 T.C. 752, 759 (1974).
The Treasury Department explained and clarified
§ 901(b)(1) in a 1983 regulation, Treasury Regulation 1.901-
2, which the parties agree governs our case. We follow our
sister Courts of Appeals in according it the force of law. See,
e.g., Texasgulf, Inc. v. Comm’r, 172 F.3d 209 (2d Cir. 1999);
Amoco Corp. v. Comm’r, 138 F.3d 1139 (7th Cir. 1998).
The regulation’s purpose is to define “income, war
profits, [or] excess profits tax” within the meaning of I.R.C.
§ 901(b)(1). The regulation combines those statutory terms
into the single concept of an “income tax.” Treas. Reg. §
1.901-2(a)(1). 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.” Id. § 1.901-2(a)(1)(ii). (It also
requires that the foreign tax be a “tax,” which is not at issue
here.) The regulation then provides that a foreign assessment
has a tax “character” if it is “likely to reach net gain in the
normal circumstances in which it applies.” Id. § 1.901-
2(a)(3)(i). And it is “likely to reach net gain . . . if and only if
the tax, judged on the basis of its predominant character,” 1
1
Because the regulation repeats the phrase “predominant
character” throughout its definitions, both the Tax Court and
PPL on appeal suggest that it applies a “predominant
character standard” independent of the three requirements.
6
satisfies each of three requirements: the “realization”
requirement, the “gross receipts” requirement, and the “net
income” requirement. Id. § 1.901-2(b)(1) (emphases added).
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. Id. § 1.901-2(b)(2).
That is incorrect. We must assess whether a foreign tax
satisfies each of the regulation’s three requirements “judged
on the basis of its predominant character.” Treas. Reg.
§ 1.901-2(b)(1), (b)(2), (b)(3), (b)(4). We may not, however,
simply ask whether the “predominant character” of a foreign
tax is that of a U.S. income tax without addressing the
requirements. The Court of Claims did essentially that in a
pair of cases that predated the Treasury regulation governing
our case. See Inland Steel Co. v. United States, 677 F.2d 72,
80 (Ct. Cl. 1982) (per curiam); Bank of Am. Nat’l Trust &
Sav. Ass’n v. United States, 459 F.2d 513, 519 (Ct. Cl. 1972).
A single paragraph in the Treasury regulation’s
preamble purports to adopt both the Court of Claims’
approach and the three-requirement test. Creditability of
Foreign Taxes, 48 Fed. Reg. 46,272, 46,273 (Oct. 12, 1983).
Those two approaches to § 901 are, at the least, in tension
with one another. We resolve this tension in favor of the text
of the regulation, which does not include the preamble. In
doing so, we follow the Second Circuit’s decision in
Texasgulf, which considered the same foreign tax that the
Court of Claims had in Inland Steel but reached the opposite
result, the former deciding that the Ontario Mining Tax was
creditable under § 901, Texasgulf, 172 F.3d at 216-17, and the
latter ruling that it was not, Inland Steel, 677 F.2d at 87.
7
The gross receipts requirement is that the tax is imposed on
gross receipts or an amount not greater than gross receipts.
Id. § 1.901-2(b)(3). The net income requirement is that
computing the tax demands deducting from gross receipts the
costs and expenses incurred in earning those receipts. Id.
§ 1.901-2(b)(4). We determine whether each requirement is
met “judged on the basis of [the] predominant character” of
the tax. Id. § 1.901-2(b)(2), (b)(3), (b)(4). We do so mindful
that “[b]ecause § 901’s exemption from taxation is ‘a
privilege extended by legislative grace,’ it is strictly
construed.” Texasgulf, 172 F.3d at 214 (quoting Inland Steel
Co. v. United States, 677 F.2d 72, 79 (Ct. Cl. 1982) (per
curiam)).
The three requirements concern the timing and the
base of the foreign tax. The realization requirement, one of
timing, ensures that the taxpayer has received income before
being obligated to pay taxes on it. See Helvering v. Horst,
311 U.S. 112, 115 (1940) (“‘[R]ealization’ is not deemed to
occur until the income is paid.”). The main effect of this
requirement is to exclude from “income” the appreciation in
value of property that its owner has not yet sold. The gross
receipts and net income requirements present questions about
the tax base, the amount on which the tax is levied. The
amount that a particular corporation owes is the product of its
tax base multiplied by its tax rate.
B. The Tax Base
The parties offer dueling perspectives on the base of
the windfall tax. In the Commissioner’s view, the tax base is
what the U.K. statute says it is: the difference between two
imputed values of each affected company. The first value is
the company’s “profit-making value,” defined as its average
annual profit during its “initial period” (that is, average profit
per day over the initial period, multiplied by 365) times 9, the
8
assumed price-to-earnings ratio. The second value is the
company’s “flotation value,” the amount for which the U.K.
Government sold the company to investors. Neither value
represents the company’s gross receipts, nor does the tax base
account for recognizable costs and expenses such as
employee costs. Thus, the Commissioner contends, the
“windfall tax” fails to meet either the gross receipts or the net
income requirement under the U.S. regulation.
In PPL’s view, looking through the form of the tax to
its substance reveals that “the [t]ax [i]s, in substance, a tax on
profits, specifically on excess profits.” PPL Br. at 43 (citation
and internal quotation marks omitted). Our classification of a
foreign tax hinges on its economic substance, not its form.
See Boulware v. United States, 552 U.S. 421, 429 (2008)
(“[T]ax classifications . . . turn on ‘the objective economic
realities of a transaction rather than . . . the particular form the
parties employed’; a ‘given result at the end of a straight path
is not made a different result . . . by following a devious
path.’”) (citations omitted). PPL’s expert testimony purports
to establish that initial-period profit would satisfy the gross
receipts and net income requirements.
In our view, PPL’s formulation of the substance of the
U.K. windfall tax is a bridge too far. No matter how many of
PPL’s proposed simplifications we may accept, we return to a
fundamental problem: the tax base cannot be initial-period
profit alone unless we rewrite the tax rate. Under the
Treasury Department’s regulation, we cannot do that.
PPL’s proposal and its fatal flaw are best understood in
algebraic terms. Once again, the U.K. statute computes each
company’s tax thus:
Tax = 23% x [(365 x (P / D) x 9) - FV],
9
where 23% is the tax rate, P is the company’s initial-period
profit, D is the length of the initial period in days, and FV is
the company’s flotation value. Were this a tax on initial-
period profit, as PPL contends that it is in substance, the tax
base would be simply P, so that we could express the tax
thus:
Tax = 23% x P.
No amount of emphasis on substance over form can take us
from the first equation to the second.
If profit is in essence the only variable in the tax base,
we would first need to explain away the other two variables
that the U.K. statute puts there. For the sake of argument, we
do so as PPL suggests. First, we assume that the “initial
period” for all companies is 1,461 days long—in other words,
that D equals 1,461. Twenty-nine of the 32 affected
companies had initial periods of 1,461 days—four years (4 x
365) plus one day for leap year—or just shy of it. Second, we
assume that each company’s flotation value (the variable FV)
is not relevant for the purpose of satisfying the regulation’s
three requirements. PPL contends that we should do so
because the flotation value in the U.K. windfall tax merely
gives that tax the form of historical “excess profits” taxes. 2
2
Section 901(b)(1) establishes a credit for “any income, war
profits, and excess profits taxes” paid to a foreign nation. As
we noted above, the relevant Treasury regulation treats those
three taxes as though they are identical. Treas. Reg. §
1.901-2(a)(1). PPL protests that the regulation “does not
address the elements necessary to [distinguish] ‘excess
profits’ from ‘normal profits.’ . . . . One must search [beyond
the regulation] to determine the predominant character of an
10
These two modifications would make the tax base
appear to be quite different. Rather than the statutory
formula, that is,
Tax = 23% x [(365 x (P / D) x 9) - FV],
we would confront this new formula:
Tax = 23% x [(365 x (P / 1,461)) x 9],
because we have substituted 1,461 for D and eliminated FV.
And because P is the only variable left, we may combine the
remaining numbers in the tax base. Multiplying 365 by 9,
excess profits tax.” PPL Br. at 36. In other words, PPL
submits, the regulation cannot tell us what an “excess profits”
tax is because it does not define that term specifically.
Instead, we are invited to look to World War I-era “excess
profits” taxes, which, we are told, would render flotation
value irrelevant to our analysis.
But this argument merely suggests that the regulation
misinterprets the statute. The regulation expressly defines an
excess profits tax as an “income tax,” which for the purposes
of the regulation is a tax that satisfies the realization, gross
receipts, and net income requirements. PPL could have
argued that the Treasury Department’s regulation was
arbitrary or capricious because it mingles “excess profits
taxes” with the other statutory terms. But it did not. Instead,
PPL agrees with the Commissioner that Treasury Regulation
1.901-2 governs this case. See id. at 30-33, 35, 52. We
nonetheless indulge for the sake of argument PPL’s
contention that historical practice allows us to cast flotation
value aside. Doing so does not affect our holding.
11
then dividing by 1,461, equals roughly 2.25. Thus, we could
express the U.K. windfall tax even more simply:
Tax = 23% x [2.25 x P].
PPL’s two proposed simplifications boil down to this
formula.
Even accepting those simplifications, this tax base
would violate the gross receipts requirement under the
following logic:
· The tax base that PPL’s two simplifications produce is
2.25 times profit;
· Profit equals gross receipts minus expenses;
· Thus the tax base that PPL’s two simplifications
produce is 2.25 times gross receipts minus 2.25 times
expenses;
· The gross receipts requirement addresses the income
portion of a tax base, whereas the net income
requirement addresses the expense portion of a tax
base; and
· Hence the income portion of this tax base—2.25 times
gross receipts—violates the gross receipts requirement,
which limits the basis of a tax to gross receipts or an
approximation thereof “likely to produce an amount
that is not greater than [their] fair market value.”
Treas. Reg. § 1.901-2(b)(3)(B) (emphasis added).
PPL attempts to skirt this logic by changing the tax
rate. A 23% tax on 2.25 times profit, PPL observes, is
mathematically identical to a 51.75% tax on profit, because
23% times 2.25 equals 51.75%. PPL Br. at 25-26. In other
12
words, returning to our formula, PPL would make one last
modification:
Tax = 23% x [2.25 x P] = 51.75% x P.
Rewritten in this way, the tax base is profit alone. This tax
base, PPL posits, would not offend the gross receipts
requirement because the starting point for calculating profit is
gross receipts.
However, changing the tax rate in this way to avoid a
problem with the tax base would read the gross receipts
requirement out of the regulation. This we decline to do. An
example from the Treasury regulation illustrates why our law
does not tolerate such a mathematical maneuver. In the
example, another country imposes a tax on the extraction of
petroleum. Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3. The
country deems “gross receipts” to equal 105% of the market
value of the petroleum extracted. That is, the starting point
for the tax base is 105% of each affected company’s gross
receipts from petroleum. The regulation disallows a credit for
the tax because it “is designed to produce an amount that is
greater than the fair market value of actual gross receipts.”
Id. As the tax would not even be creditable up to the amount
imposed on 100% of gross receipts, less associated costs, the
entirety of the tax fails to satisfy the requirement. This all-or-
nothing result is so because the regulation mandates that “a
tax either is or is not an income tax, in its entirety, for all
persons subject to the tax.” Id. § 1.901-2(a)(1)(ii) (emphasis
added). If 105% of gross receipts (barely more than actual
receipts) does not satisfy the requirement, then 225% is in the
same boat but another ocean.
In this example, as with the U.K. windfall tax,
manipulating the tax rate could in theory fix the problem.
Say that the tax rate on the hypothetical extraction tax is 20%.
13
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. The regulation forbids that outcome. 3
3
To repeat, a tax must satisfy the regulation’s three
requirements to be creditable. A tax’s failure to satisfy any
one of the three tests renders it not creditable, regardless
whether it satisfies the other two tests. Because the U.K. tax
fails to satisfy the gross receipts requirement, it is not
creditable. Nonetheless, we also believe that (laying aside
any discussion of the net income requirement) the tax fails to
satisfy the realization requirement. To meet that test, the tax
must be imposed “[u]pon or subsequent to the occurrence of
events (‘realization events’) that would result in the
realization of income . . . .” Treas. Reg. § 1.901-
2(b)(2)(i)(A). The “income” that PPL asserts is at issue here
is initial-period profit. But as we have explained, the amount
being taxed (the “income”) was greater than initial-period
profit. The U.K. windfall tax did not ensure that the
companies had actually realized the amount being taxed. In
SWEB’s case, for example, initial-period profit was £306.2
million, but the taxable amount was approximately £393.1
million after subtracting flotation value. SWEB did not
realize the full latter amount as profit over its initial period.
See Eisner v. Macomber, 252 U.S. 189, 211 (1920) (holding
14
III. Conclusion
Even if we accept PPL’s contention that the U.K.
windfall tax is in substance a 23% tax on 2.25 times profits,
that tax fails to satisfy at least the gross receipts requirement.
Without changing the tax rate, the calculation of the tax base
begins with an amount greater than gross receipts. And we
may not manipulate the tax rate to address a question about
the tax base.
Thus, we hold that the windfall tax is not creditable
and reverse the decision of the Tax Court.
that income is not realized unless it “is available for actual
distribution”). Putting aside the Commissioner’s other
arguments, this alone belies PPL’s claim that the windfall tax
meets the realization requirement, as the tax was not imposed
on past profit (and certainly not on excess profit, which of
course is less than total profit).
15