135 T .C . . .No . 1 5

N

4.

135 T .C . . .No . 1 5

UNITED STATES TAX COUR T

PPL CORPORATION & SUBSIDIARIES, Petitioner M .

COMMISSIONER .OF"INTERNAL REVENUE, Responden t

Docket No . . 25393-07 .

#` Filed

September

9, 2010.

Held : The United Kingdom'windfall tax enacted on

July 2, 1997, and imposed on certain British utilities

is a creditable tax under sec . 901, I .R .C .

Richard E . May ,

Mark B . Bierbower , and Timothy L . Jacobs ,

for petitioner .

Melissa D . Arndt ,

Allan E . Lang ,

Michael C . Prindible , .and

R . Scott Shieldes , for respondent .

HALPERN,

Judge : PPL Corp . (petitioner) is the common parent

of an affiliated group of corporations (the group) making a,

consolidated return of income . By notice of deficiency ,

SERVED Sep 09 2010

respondent determined a deficiency of $10,196,874 in the group's

Federal income tax for its 1997 taxable (calendar) year and also

denied a claim for refund of $786,804 . The issues for decision

are whether. respondent properly (1) denied the claim for th e

refund, which is related to the creditability of the United

Kingdom (U .K .) windfall tax paid by petitioner's indirect U .K .

subsidiary (the windfall tax issue), (2) included-as dividend

income a distribution that petitioner received from the same

indirect U .K . subsidiary, but which, within a few days, the

subsidiary rescinded and petitioner repaid (the dividend

rescission issue), and (3) denied depreciation deductions that

petitioner's U .S . subsidiary claimed for street and area lighting

assets . We disposed of the third issue in a previous report,

PPL

Corp . & Subs . v . Commissioner , 135 T .C . (2010), and we

dispose of the remaining issues here .

Unless otherwise stated, all section references are to the

Internal Revenue Code in effect for 1997, and all Rule references

are to the Tax .Court Rules of Practice and Procedure . With

respect to the two issues before us here, petitioner bears the

burden of proof . See Rule 142(a) . 1

'Petitioner has not raised the issue of sec . 7491(a), which

shifts the burden of proof to the Commissioner in certain

situations . We conclude that sec . 7491(a) does not apply because

petitioner has not produced any evidence that it has satisfied

the preconditions for its application . See sec . 7491(a)(2) .

FINDINGS OF FACT

Stipulations

-

The parties have entered into a first, second, and third

stipulation of facts . The facts stipulated are so found . The

stipulations, with accompanying exhibits, are incorporated herein

by this reference .

Petitioner's Business and Its U .K . Operatio n

Petitioner is a Pennsylvania corporation that was known

during 1997 as PP&L Resources', Inc . It is a global energy

company . Through its subsidiaries, it produces electricity,

sells wholesale and retail electricity, "and delivers electricity

to customers . It provides energy services in the United States

(in the Mid-Atlantic and the Northeast) and in the United

Kingdom . During 1997, South Western Electricity plc (SWEB), a

U .K . private limited liability company, was petitioner's indirect

subsidiary .' Its principal activities at the time included the

distribution of electricity . It delivered electricity to

approximately 1 .5 million'customers in its 5,560-square-mile

service area'from Bristol and Bath to Land's End in Cornwall .

SWEB also owned electricity-generating assets .

'SWEB was originally incorporated as a U .K . public limited

liability company in 1987, but, as described infra , it was

privatized in 1990 . The appendix shows SWEB ' s relationship to

petitioner in 1997 .

Privatization of U .K . Companie s

The Conservative Party won control of the U .K . Parliament in

the 1979 elections . It retained control through May 1997, under

the leadership of Margaret Thatcher and John Major .

Between 1979 and 1983, the Conservatives privatized mostly

companies that were not monopolies (e .g ., manufacturing

companies) and, for that reason, did not require specific

economic regulation . Between 1984 and 1996, however, the U .K .

Government privatized more than 50 Government-owned companies,

many of which were monopolies .

The U .K . Government privatized those companies largely

through public flotations (share offerings) at fixed price

offers, which involved the transfer of those Government-owned

enterprises to new public limited companies (plcs), followed by

what was essentially a sale of all or some of the shares in the

new plcs to the public .3 The plcs then became publicly trade d

3The U .K . Government hired investment banks and other

advisers to assist it in setting the initial share prices,

structuring the offers, and marketing the shares to investors .

The new plcs were not subject to a gains tax on transfers of

stock to the general public, a result made possible by an

amendment to the then-existing U .K . law .

Under sec . 171 of the U .K . Taxation of Chargeable Gains Act,

1992 (TCGA), companies within a group (generally, a parent and

its 75-percent-owned subsidiaries) may transfer assets between

members of the group without incurring a capital gains charge .

The effect of TCGA sec . 171 is to defer the chargeable gain on

asset appreciation until a group member transfers the asset

outside the group, at which point the gain becomes chargeable t o

(continued . . .)

companies listed on the-London Stock Exchange . In most-cases,

the floated-shares opened for trading at a-substantial premium

over the price the flotation investors paid for the shares .

In December 1990, the U .K . Government privatized 12 regional

electric companies (RECs), including`SWEB . The ordinary shares

of each REC were offered to the public at £2 .40 per share in

connection with the flotation of-those shares .

The 32 U .K . Government-owned companies that were privatized

and that ultimately became liable for the windfall tax (the"

privatized utilities` or windfall tax companies) and the-years in

which they were privatized are as follows': .Year

Compan y

1984

50 .2 .percent of British Telecommunications plc

(British Telecom )

1986

1987

British Gas pl c

British Airports Authorit y

3 ( . .

. continued )

that transferor . Under the TCGA .as originally enacted, however,

the transfer, outside the group of the stock of a group member

holding an appreciated asset would not . trigger any capital gains

charge to the transferor . (The nongroup transferee, meanwhile,

would receive a basis in the stock that would reflect the, value

of the'underlying asset .) . TCGA sec ., 179 was enacted to make the

tax consequences of the stock transfer similar to those of the

asset transfer, although only if the transfer of the stock of the

group member holding the asset occurred within 6 years of that

member's acquisition of the asset . ; Because the transfers of the

stock of-the privatized utilities to the general public pursuant

to the flotations of-that stock would have triggered th e

.application of TCGA sec . 179 and"taxation of the appreciation

inherent in the assets the companies received from the various

U .K . Government-owned enterprises,'-Parliament= specifically

exempted the privatization share transfers from the application

of that provision .

- 6

-

198 9

1990

10 water and sewerage companies (the WASCs )

The 12 REC s

1991

60 percent of National Power plc and Powergen pl c

(the generating companies )

1991

Scottish Power plc and Scottish Hydro-Electric pl c

(the Scottish electricit y companies )

Northern Ireland Electricity (NIE )

Railtrack plc (Railtrack )

88 .5 percent of British Energy plc (Britis h

Energy) (which owned U .K . nuclear generating

1993

1996

1996

stations )

Regulation of the Windfall Tax Companie s

The Electricity Act of 1989, c . 29, sec . 1, created the

position of U .K . Director General of Electricity Supply, a

position that Professor Stephen C . Littlechild (Professor

Littlechild) held from its creation in 1989 through 1998 . 4

Before that appointment, in 1983, the U .K . Secretary of

State asked Professor Littlechild for his advice on how to

regulate British Telecom in the light of its impending

privatization . Professor Littlechild recommended a regulatory

scheme which regulated prices rather than, as in the United

States, maximum profits or rates of return . The premise of the

scheme, which became known as "RPI - X",5 was that, if the

Government fixed prices (but not profits) for a set number o f

4Professor Littlechild was professor of commerce and head of

the Department of Industrial Economics and Business Studies,

University of Birmingham (on leave, 1989 to 1994) from 1975 to

1994 (and honorary professor from 1994 until 2004) .

5RPI, which stands for retail price index, is comparable to

the CPI (consumer price index) used for various purposes in the

United States .

years, the privatized companies would have an incentive to reduce

costs to maximize profits during that period . Prices would-be

reset (presumably downward) at the start of the,next regulatory

period, to garner for consumers the fruits of the prior period's

cost reductions . Profits might in a sense become excessive

during any regulatory period (because a company achieved greaterthan-anticipated savings and there was .no mechanism for midperiod correction) ., but balance would be reestablished at the

start of the next period . The goal was to increase efficiency,

encourage competition, and protect consumers . . Under RPI - X,

prices were not allowed to .increase during the regulatory period,

except to allow for inflation (i .e ., increases in RPI) less an

amount (the X factor, which did not vary during the period)

intended to reflect expected, increasing efficiency .

The U .K . Government set the X factors for .the firs t

regulatory periods, just before the initial privatization, to be

effective for what was, in most cases, the 5-year period after

privatization . Industry regulators subsequently reset the X

factors, typically every 4 or 5 years . In some cases ,

particularly where investment requirements were high (e .g ., in

the case of companies that had underinvested while under public

ownership), the X factor might be positive (RPI + .X) : That was

the case for most of the RECs and WASCs .

- 8 Each of the regulatory bodies for the privatized utilities

followed the RPI - X ,regulatory method, which was adopted for 29

of, the 32 windfall tax companies,,the exceptions being the

generating. companies . On March 31, 1990, the RPI - X methodology

as applied to the RECs came into effect for the 5-year period

ending March 31, 1995 . As noted supra , because the RECs were in

need of large capital expenditures during the initial 5-year

period, the U .K . Government .set price controls for the RECs in

the form of RPI + X ; i .e ., it provided for annual increases in

electricity distribution charges above the rate of inflation

rather than reductions in those charges .

Utility Profits, Share Prices, and Executive Compensation During

the Initial Postprivatization Perio d

During the initial postprivatization period (the initial

period), the privatized utilities were able to increase

efficiency and reduce operating costs to a greater degree than

had been expected when the initial price controls were

established . That ability led to higher-than-anticipated

profits,6 which, in turn, led to higher-than-anticipated

dividends and share price increases for the privatized utilities .

The large profits, dividends, and share price increases resulte d

6Among the privatized utilities, the RECs and the WASCs were

particularly profitable during the initial period in that they

recovered nearly all (over 90 percent for the WASCs and over 80

percent for the RECs) of their shareholders' initial investment

at flotation within the first 4 years .

- 9 in sharply increased compensation for utility directors and

executives, which, in some cases, arose through their share

ownership and through bonus schemes . The popular press referred

to those executives as "fat cats" . .

The public viewed the privatized utilities' initial period

profits as excessive in relation to their flotation values . It

also viewed the initial period compensation paid to the directors

and executives of those companies as excessive . Those concerns,

as well as the increases in dividends and share prices, resulted

in considerable public pressure on the utility industry

regulators to intervene and take action that would result

immediately in lower prices, before the expiration of the initial

5-year period . But because the incentive for increased

efficiency (and, ultimately, lower prices) depended on the'

regulators' not intervening until the end of the defined price

control period, the regulators resisted that pressure and did not

act until the end of the initial period, at which point they did

tighten price controls and thereby transfer the benefit of

reduced prices to utility customers . -Despite those price

adjustments, the public retained a strong feeling that the

privatized utilities had unduly profited from privatization and

that customers had not shared equally in .the gains therefrom .

10 Development of the Windfall Ta x

Although the Labour Party had been fundamentally opposed to

privatization, particularly with respect to the utilities, by

1992 the party reasoned that, because it would be costly and,

given that much of the voting public had embraced share

ownership, potentially unpopular, renationalization of those

companies (when the party regained control of the Government) was

unrealistic . The issue, then, was how the party might best

channel the public concerns into developing policy .

As early as 1992, the British press reported that the policy

of an incoming Labour Party might include "a `windfall' tax on

the profits of privatized utilities such as gas and electricity ."

By 1994 the idea of a windfall tax had become a regular feature

in all Labour Party speeches and programs, and, in 1997, the

party campaigned on a platform promising that it would (1) impose

a windfall tax on the previously privatized utilities and (2)

implement a welfare-to-work youth employment training program

that the windfall tax would fund . Specifically, the Labour

Party's 1997 Election Manifesto contained the following promise :

We will introduce a Budget * * * to begin the task of

equipping the British economy and reforming the welfare

state to get young people and the long-term unemployed

back to work . This welfare-to-work programme will be

funded by a windfall levy on the excess profits of the

privatised utilities * * * .

In May 1996, before the issuance of that manifesto, certain

members of the Labour Party's shadow treasury team, which

- 11 included Geoffrey Robinson (Mr . Robinson), a Member of

Parliament, began designing the-U .K . windfall tax legislation

that the party would introduce to'Parliament in the'likely event

that it won the 1997 election . To that-end, Mr . Robinson

commissioned members of the tax consulting firm Arthur Andersen

(the Andersen team) to assist the Labour Party's shadow treasury

team in developing the tax, . The Andersen team consisted

principally of Stephen Hailey, Christopher Osborne (Mr . Osborne),

and Christopher Wales (Dr . Wales) . The tax that the Andersen

team devised was essentially the windfall tax that Parliament

enacted in July 1997 . Mr . Osborne and Dr . Wales were the most

involved members of the Andersen team .

During their-initial consideration of the design .of the

windfall tax, . the Andersen team proposed three "simple" and three

"complex" solutions for structuring the tax- .' The "simple"

.solutions were to tax either-(1) turnover (gross receipts), (2)

assets, or (3) profits . -The "complex" solutions were to tax'(1)

excess profits, (2) excess shareholder returns, or (3) a

"windfall" amount . The team members rejected the three "simple"

solutions and the first two "complex" solutions for a variety of

reasons . For example, they considered that a straightforward tax

on profits, if prospective, would pose a risk of financial

manipulation by the target companies (and, therefore, uncertainty

as to its yield), a risk of . public perception that it would

12 compromise existing corporate tax reliefs, and, if retrospective,

a risk of criticism that it constituted a second tax on the same

profits . And although Mr . Robinson and the Andersen team

considered that there was ample rationale for a straightforward

tax on either excess profits or excess shareholder returns, they

concluded that the negative aspects (e .g ., the difficulty in

computing the "excess" amounts, the need for a retrospective tax

to be assured of raising a target amount, and, in the case of a

tax on excess shareholder returns, the likelihood of taxing the

wrong shareholders, i .e ., shareholders who did not realize those

returns)-outweighed the positive ones .

As a result of the perceived difficulties with the other

approaches, Mr . Robinson and the Andersen team settled on the

idea of a tax that would be a one-time (or, in U .K . parlance, a

"one-off") tax on the "windfall" to the privatized utilities o n

.privatization . The approach would be to impute a value to each

company at privatization, using an appropriate price-to-earnings

ratio for each company's profits during the first 5 years after

flotation, recognize the "windfall" (the difference between the

imputed value and the flotation price) as value forgone b y

taxpayers, and tax the privatized utilities on that "windfall"

using established principles from capital gains tax legislation . '

7In November 1996, in a presentation to Gordon Brown

(Labour's next Chancellor of the Exchequer) and the Labou r

(continued . . .)

- 13 They reasoned that such a tax-would factor in the privatized

utilities' "excess" profitability,-the discount on privatization,

the unanticipated efficiency gains, and the perceived weakness of

the initial regulatory regime .

In November 1996, the foregoing proposal was reviewed and

approved by Gordon Brown`(who became Chancellor of the Exchequer

when Labour returned to power in 1997) and the-Labour Party's

shadow treasury team, and, after the Labour Party regained powe r

J

in 1997, by the U .K . Treasury Department, Inland-Revenue, and th e

Parliamentary drafters (who drafted the actual legislative

language), after which the draft legislation was disseminated to

members of Parliament-and enacted in July 1997 .

'( . . .continued)'

Party's shadow treasury team, the,Andersen team set forth the

average price-to-earnings ratios for the various privatized

utility groups during the first 5 years after privatization,

which ranged from a .high of 12 .7 after-tax and 9 .4 pre-tax (both

for the Scottish Electricity, companies) to a low of 9 .4 after-tax

(for the WASCs) and 7 .`3 pre-tax ( .for the RECs) . The presentation

also set forth the potential revenue yield from .using price-topre-tax earnings ratios of 6 through 8 to ascertain the imputed

values of the companies and showed that a potential revenue yield

of £6 .4 billion could be achieved by using for that purpose

either a pre-tax ratio of 6 or an after-tax ratio of 8 .25 coupled

with a 33-percent windfall tax rate on the excess of the imputed

value over the flotation price .

14 Description,of the Windfall Ta x

On July 31, 1997, Parliament enacted-,the windfall tax . It

constituted part I of chapter-58, Finance (No . 2) Act 1997 (the

Act), and provided, in clause 1, as follows :

1 .--(1) Every company which, on 2nd July 1997, was

benefitting from a windfall from the flotation of an

undertaking whose privatisation involved the impositionof economic regulation shall be charged with a tax (to

be known as the "windfall tax") on the amount of that

windfall .

(2) Windfall tax shall be charged at the rate of

23 per cent .

(3) Schedule 1 to this Act (which sets out how to

quantify the windfall from which a company was

benefitting .on 2nd July 1997)-,shall have effect .

Clause 2 makes clear that the windfall-tax is to apply to the .32

privatized utilities, clause .3 provides for the administration of

the tax by the'Commissioners of Inland Revenue, clause 4 covers

the relationship between the windfall tax and profit-related pay

schemes under the then-existing U .K . law, and clause 5 sets forth

the definitions of terms used in part I .

Paragraphs 1 and 2 of schedule 1, referred to in claus e

1(3), provide in pertinent part as follows :

1 .--(1) * * * where-a company was benefitting on

2nd July 1997 from a windfall from the flotation of an

undertaking whose privatisation involved the imposition

,.of economic regulation, the amount of that windfall .

shall be taken for the purposes'of this Part to be the

excess'(if any) of'the amount specified in subparagraph (2)(a) below over the amount specified in

sub-paragraph (2)(b) below .

- 15

-

(2) Those amounts are the following amounts

that is to say-(a)

th e value in profit-making terms o f

th e disposal made on the occasio n

of the company's flotation ; and

(b)

, the value which for privatisatio n

purposed was put on that disposal .

* *~

Value of : a disposal in profit- making term s

2 .--(l) * * * the value in profit-making'terms of

the disposal made on the occasion of a company's

flotation is the amount produced by multiplying the

average annual profit for the company's initial period

by .the applicable price-to-earnings ratio .

(2) For-the purposes of this paragraph the average

annual profit for a company's initial period is the

amount produced by the following formula-A 365 x P/D Where--

A is the average annual profit for'the company's initial

period ;

P is the amount * * * of the total profits for the company's

initial period ; and

D is the number. of-days in :'the company's initial period .

(3) For the purposes of this paragraph the applicable

price-to-,earnings ratio is 9 .

Paragraph 3 defines "value put on a disposal fo r

privatisation purposes" ; i .e ., the ,flotation value . Paragraph 4

provides for an appropriate percentage reduction of a company's

"value in profit-making terms" and its flotation value where les s

than 85 percent of the company's ordinary share capital was

"offered for disposal on the occasion of the company's

16 flotation ." Paragraph 5 sets forth the criteria for determining

a company's "total profits for a company's initial period" and

.generally provides that those profits are its after-tax profit s

for financial reporting purposes as determined under relevant

provisions of the U .K . Companies Act 1985 .8 Paragraph 6 defines

the term "initial period" in relation to a company as the period

encompassing the company's 4 financial years after flotation or

such lesser period of existence for companies operating for less

than 4 financial years after privatization and before April 1,

1997 .9 Paragraph 7 provides for the apportionment of th e

windfall amount subject t

tax between companies that previousl y

had been a single privatized company . Lastly, paragraph 8

defines the term "financial year" and other terms for purposes of

the windfall tax legislation .

The Act required that affected companies pay the windfall

tax in two installments : one-half on or before December 1, 1997,

and the other half on or before December 1, 1998 .

'The parties stipulate that profit for a windfall tax

company's initial period was equal to the company's "profit on

ordinary activities after tax" as determined under U .K . financial

accounting principles and standards and as shown in the company's

profit and loss accounts prepared in accordance with the U .K .

Companies Act of 1985, as amended .

'From this point forward, the term "initial period" refers

to the 4-year windfall tax initial period rather than the 5-year

initial . postprivatization period under the RPI - X regulatory

regime .

- 17 Public Statements Regarding the Windfall Ta x

On July 2, 1997 ,

Exchequer ,

Gordon Brown ,

then Chancellor of the

gave the Budget Speech announcing the windfall tax,

and he described the windfall tax as follows :

Our reform,to the welfare state--and the programme

to move the .unemployed from welfare to work--is funded

by a new and one-off windfall tax on the excess profits

of the privatised utilities .

*

In determining the details of the tax, I believe I

have struck a fair balance between recognising the

position of the utilities today and their undervaluation and under-regulation at the time of

privatisation .

The windfall tax will be related to the

excessively high profits made under the initial regime .

A company's tax bill will be based on the

difference between the value that was placed on it at

privatisation, and a more realistic market valuation

based on its after-tax profits for up to the first 4

full accounting years following privatisation .

Also on July 2, 1997, Inland Revenue issued an announcemen t

describing the tax as follows :

The Chancellor today announced the introduction of the

proposed windfall tax on the excess profits of the

privatised utilities . The one-off tax will apply to

companies privatised by flotation and regulated by

statute . The tax will be charged at a rate of 23 per

cent on the . difference between company value,

calculated by reference to profits over a period of up

to four years following privatisation, and the value

placed on the company at the time of flotation . The

expected yield . is around 5 .2 billion Pounds .

.

The Inland Revenue announcement also stated that the price-

to-earnings ratio of .9 "approximates to the lowest average

- 18 -

price/earnings ratio of the taxpaying companies during the .

relevant periods, grouped by sector . "

Around that same time, Her Majesty's Treasury issued a

publication entitled "Explanatory Notes : Summer Finance Bill

1997", which describes in detail the various clauses of the

windfall tax, and which contains a section entitled ."Background",

stating :

The introduction of the windfall tax is .in

accordance with the commitment in the Government's

Election Manifesto to raise a tax on the excess profits

of the privatised utilities .

The profits made by these companies in the years

following privatisation were excessive when considered

as a return on the value placed on the companies at the

time of their privatisation by flotation . This is

because the companies were sold too cheaply and

regulation in the relevant periods was too lax .

The windfall tax will raise around £5 .2 billion

and fund the Government's welfare to work programme .

Parliamentary Debate Preceding Enactment of the Windfall Ta x

Mr . Robinson, in opening the debate in the House of Commons

on the windfall tax legislation, offered the following

introductory observations :

Clause 1 heads a group of provisions that together

introduce the windfall tax, thus meeting the commitment

that . we made in our election manifesto to introduce a

windfall levy on the excess profits of the privatised

utilities . Those companies were sold too cheaply, so

the taxpayer got a bad deal . Their initial regulation

in the period immediately following privatisation was

too lax, so the customer got a bad deal . .

As a result, the companies were able to make profits

that represented an excessive return . on the value

- 19 placed on them at,the time of their flotation . We are

now putting right the failures of the past by levying a

one-off tax . The yield of around £5 .2 billion wil l

fund our welfare-to-work programme, and the new deal

that we have announced for the young long-term

unemployed and schools .

Clause 1 provides a one-off charge, set at a rate of 23

per cent . It also gives effect to schedule 1, which

will be debated in Standing-Committee . It may be

helpful if I set the clause in context by explaining

briefly how the windfall tax works .

Windfall tax is charged on the difference between the

value of the company, calculated by reference to the

profits made in the -initial period'after privatisation,

and the value placed on the company at the time of

privatisation . The value of the company is calculated

by multiplying the average annual profit after tax for,

normally, the first four financial years after

flotation, by a price-to-earnings ratio'of nine . That

ratio approximates to the lowest average * * * sectoral

price-to-earnings ratio of the companies liable to the

tax . * * *

The Conservative Party Shadow Chancellor of the Exchequer,

Peter Lilley, MP (Mr . Lilley),

summarized his party's opposition

to the windfall tax, and, in particular, clause 1 imposing the

tax, as follows :

We have four . major criticisms .of-the clause and the

windfall tax that it initiates- . First, the clause

makes it clear that the tax will not be borne by the

so-called fat cats and speculators, criticisms of whom

justified its introduction . Secondly, it makes no

meaningful attempt to define what is,a windfall and

should therefore bear the tax . Thirdly, it increases

instead of reduces cost to customers ; any improved

profitability should be passed on to customers in the

form of lower prices . Finally, it is retrospective,

arbitrary and symptomatic of the Government's belief in

arbitrary government, rather than in government by

known and predictable rules .

20 Mr . Lilley's comments during the debate illustrate his

understanding of how the tax would affect the privatized

utilities :

They [the government] have taken average profits over

four years after flotation . If those profits exceed

one ninth of the flotation value, the company will pay

windfall tax on the excess .

And further :

Essentially, the windfall tax boils down to a tax on

success . Companies that failed to improve their

profitability over the said period will pay much less

or even no windfall tax .

Other members . of the Conservative Party repeated the idea

that the windfall tax was a tax on profits or on success .

Several Labour Party members defended the tax as a

legitimate method of recouping the difference between what should

have been charged for the privatized utilities at the time of the

various privatizations and the actual flotation prices . Fo r

example, one such member, Mr . Hancock, observed :

The overwhelming majority of people have embraced the

tax because most think that they were ripped off in the

first place when the companies-were sold . The

companies were sold at hopelessly undervalued prices at

a time when most, people felt that the companies were

.better and safer in the hands of the public sector .

The legitimacy of the tax among the general public is

that they feel-that they are getting back what they

should have had in . the first place .

Another, Mr . Stevenson, echoed Mr . Hancock's remarks :

I asked the Library to do some research on the

difference between the proceeds from privatization of

the utilities, not including the railways, and their

stock market share price the minute they were floated .

21 I asked the` Library . to -tot, up the'difference . It was

almost £6 billion at the outset of privatisation and it

has increased over the years, . So the-snapshot figure

of £6 billion by which the Government undersold public

assets, and therefore robbed the public, is'a

conservative estimate .

Overall Effect of the Windfall Tax on the Windfall Tax Companies

Thirty-one of the thirty-two windfall tax companies had

a

windfall tax liability . None of the 31 companies that pai d

windfall tax had a windfall tax liability that exceeded its total

profits over its initial period . Twenty-nine of those thirty-two

companies had initial periods of 4 full financial years . Twentyseven of those twenty-nine companies had initial period s

consisting of 1,461 days, i .e ., three 36 .5-day years and one 366day (leap) year . The other 2 of those 29 companies had initial

periods of .1,456 days and 1,463 days,10 respectively . Th e

remaining three companies had initial periods of less than 4 ful l

financial years, consisting of 1,380 days ,

case of British Energy, which because of

paid no windfall tax),260 days ,

316 days, and (in the

low initial profits,

respectively .

Effect of the Windfall Tax on SWE B

Before the enactment of the windfall tax, SWEB met with

members of the shadow treasury team

( which included Mr'. Robinson )

and the Andersen team in an effort to influence the developmen t

10The parties stipulated an initial period of 1,463 days,

although that would seem to exceed 4 years, even taking into

account a leap year .

- 22 of the windfall tax . SWEB's then treasurer, Charl Oosthuizen

(Mr . Oosthuizen), was the SWEB officer principally engaged in

that effort . Upon the announcement of the windfall tax, SWEB

realized that its liability for the tax would greatly exceed its

prior estimates thereof, and it investigated ways of reducing

that liability . SWEB determined that it could reduce its

windfall tax liability if it could reduce its earnings for the 4year initial period . To that end, SWEB identified a theretofore

unidentified liability of £12 million for tree-trimming costs

(trees interfered with its distribution network) that SWEB should

have taken account of in determining its earnings for its fiscal

year ended March 31, 1995 . SWEB's outside auditor approved a

restatement of its 1995 earnings and, after an initial objection,

Inland Revenue did as well .

SWEB filed its windfall tax return with Inland . Revenue on

November 7, 1997, and paid its £90,419,265 windfall tax liability

(which was based on 4 full financial years totaling 1,461 days),

as required, in two installments, on December 1, 1997 and 1998 .

The first installment was paid 1 day after the close of SWEB's

tax year (for U .S . Federal income tax purposes) ending November

30, 1997 .

23, OPINIO N

I .

The Windfall Tax Issu e

A.

Principles of Creditabilit y

Pursuant to section 9:01(a) ` and

(b)(1),' a domestic

corporation may, claim a foreign tax credit against its Federal

income tax .liability for :`the amount °of .any income, war profits,

and excess profits taxes :paid or accrued during the taxable yea r

to any foreign . country We must decide whether the windfall tax

constitutes a creditable,-income,or excess"profits tax under

section 901 .

In Phillips Petroleum Co . v . : Commissioner , 104 T .C .'256,

283-284 (1995), we described the background, purpose, and

function of .. .the foreign tax credit provisions"of the Internal

Revenue Code as-follows :

The foreign tax credit provisions were enacted

primarily to mitigate the heavy burden of double

taxation for U .S . corporations operating abroad who

were subject to taxation in'both the''United'•States and

foreign countries .- Burnet v . Chicago 'Portrait Co . , 285

U .S . 1, 9 (1932) ; F .W . Woolworth'Co . v . Commissioner,

54 T .C . 1233, 1257 (1970) . These provisions were

originally, designed to produce uniformity of tax

burdens among U .S . taxpayers, irrespective of whether

they were engaged in business-abroad or-in the United

States . H . Rept . 1337, 83d Cong ., 2d Sess . 76 (1954) .

A secondary objective of-the-`foreign . tax credit

provisions was to encourage, or at least not to

discourage, American foreign trade . H .R . Rept . 767,

65th Cong .,'2d Sess . (1918), 1939-1 C .B . (Part 2) 86,

93 ; Commissioner v . American Metal Co :, 221 F .2d 134,

136 (2d Cir . 1955), affg . 19 T .C . 879 (1953) .

Taxes imposed by the government of any foreign

country were initially' fully-deductible in computing

- 24 net taxable income, pursuant to our income tax law of

1913 . Revenue Act of 1913, ch . 16, 38 Stat . 114 .

Specific foreign taxes became creditable pursuant to

the Revenue Act of 1918 . The foreign taxes that are

presently creditable pursuant to section 901,

specifically, income, war profits, and excess profits

taxes, have remained unchanged and are the same taxes

that were creditable in 1918 . Revenue Act of 1918, ch .

18, sec . 222(a)(1), 40 Stat . 1073 .

The definition of income, war profits, and excess,

profits taxes has evolved case by case . The temporary

and final regulations, . adopted relatively recently ,

outline the guiding principles established by prior

case law .

*

*

*

The Supreme Court in Biddle v . Commissioner , 302 U .S . 573,

579 (1938), . established the principle, uniformly followed in

subsequent caselaw and enshrined in the regulations, that, in

deciding whether a foreign tax is an "income tax" for purposes of

section 901, the term "income tax" will be given meaning by

referring to the U .S . income tax system and measuring the foreign

tax against the essential features of that system :

The phrase " income taxes paid," as used in our own

revenue laws , has for most practical purposes .a well

understood meaning * * * . It is that meaning which

must be attributed to it * * * .

The final regulations referred to in Phillips Petroleum ar e

the regulations that were issued in 1983, were in effect in 1997

(the year in issue), and remain in-effect today (sometimes, the

1983 regulations) .

Section 1 .901-2, Income Tax Regs .,_is entitled "Income, war

profits, or excess profits tax paid or accrued ." Paragraph (a)

thereof is entitled " Definition of income, war profits, or excess

25 profits tax ", and, in pertinent part, :it provides as follows

(adopting the term "income tax" to refer to-an "income", "war" ,

or "excess profits" tax) :

(1)

In general . * * * A foreign levy is an income tax

if and only if-(i) It is a tax ; and

(ii) The predominant character of that tax is that

of an income tax in the U .S . sense .

Paragraph (a) further provides that, with exceptions not relevant

to this case, "a tax either is or is not an income tax, in its

entirety, for all persons subject to the tax . "

In pertinent, part, section 1 .901-2(a)(3), Income Tax Regs . ,

defines the term "predominant character" as follows : "The

predominant character of a foreign tax is that of an income tax

in the U .S . sense * * * [i]f, within the meaning of paragraph

(b)(1) of this section, the foreign-tax is likely to reach net

gain in the normal circumstances in which it applies" .

In pertinent part, section 1 .901-2(b)(l) ., Income Tax Regs .,

provides :

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 set',for .th--in paragraphs (b)(2),

(b) (3) and- (b) (4) , respectively, - of .this section .

Pursuant to section 1 .901-2(b)(2) .(i), Income Tax Regs . (as

pertinent to this case), a foreign tax satisfies the realization

requirement :

- 26 if, judged on the basis of its predominant character, it

is imposed * * * [u]pon or subsequent to the occurrence

of events ("realization events") that would result in

the realization of income under the income tax

provisions of the Internal Revenue Code * * *

Pursuant to section 1 .901-2(b)(3)(i), Income Tax Regs . (as

pertinent to this case), a foreign tax satisfies the gross

receipts requirement "if, judged on the basis of its predominan t

character, it is imposed on the basis of * * * [g]ross receipts" .

Pursuant to section 1 .901-2(b)(4)(i), Income Tax Regs .,

a

foreign tax satisfies the net income, requirement :

if, judged on the basis of its predominant character,

the base of the tax is computed by reducing gross

receipts * * * to permit-(A) Recovery of the significant costs and expenses

* * * attributable * * * to such gross receipts ; o r

(B) Recovery of such significant costs and

expenses computed under a method that is likely to

[approximate or be greater than] recovery of such

significant costs and expenses .

Section 1 .901-2(b)(4)(i), Income Tax Regs ., further provides :

A foreign tax law permits recovery of significant costs

and expenses even if such costs and expenses are

recovered at a different time than they would be if the

Internal Revenue Code applied, E :'11 unless the time of

recovery is such that under the circumstances there is

effectively a denial of such recovery . * * * A foreign

tax law that does not permit recovery of one or more

significant costs or expenses, but that provides

allowances that effectively compensate for nonrecovery

of such significant costs or expenses, is considered to

permit recovery of such costs or expenses . * * * A

foreign tax whose base is gross receipts or gross incom e

"E .g ., items deductible under the Internal Revenue Code and

capitalized and amortized under the foreign tax system .

- 27 does not satisfy the net income'requirement except in

the rare situation where that tax is almost certain to

reach some net gain in the normal circumstances in which

it applies because costs and expenses will almost never

be so high as to offset gross receipts or gross income,

respectively, and the rate of the tax is such that after

the tax is paid persons subject to the tax are almost

certain to have net gain . * * *

The Secretary first adopted the "predominant character"

standard in the 1983 regulations . In the preamble to those

regulations (the preamble), the Secretary stated that the

standard :

adopts the criterion for creditability set forth in

Inland Steel Company v . U .S . , 677 F .2d 72 (Ct . Cl .

1982), Bank of America National Trust and Savings .

Association v . U .S . , 459 F .2d 513 (Ct . Cl . 1972), and

Bank of America National Trust and Savings Association

v . Commissioner , 61 T .C . 752 (1974) . [T .D . 7918,

1983= 2 C .B . 113, 114 . 1

In the cases the Secretary cited in the preamble and in

other, more recent, cases, the issue or test regarding the status

of a foreign tax as a creditable income tax appears to be whether

the foreign tax in question is designed to and does in fact reach

net gain in' the normal circumstances in which it applies . Thus,

in Bank of Am . Natl . Trust & Sav . Association v . United States ,

198 Ct .

Cl .

263, .274, 459 F .2d 513, 519 (1972) (Bank of Americ a

I), which the Secretary cites in the preamble, the Court of

Claims, in considering the' creditability of a gross income tax

that, on its face, was not a tax on net income or gain, concluded

that such a tax could be creditable under certain circumstances :

- 28 We do not, however, consider it all-decisive

'whether the foreign income tax is labeled a gross income

or a net income tax, or whether it specifically allows

the deduction or exclusion of the costs or expenses of

realizing the profit . The important thing is whether

the other country is attempting to reach some net gain,

not the form in which it shapes the income tax or the

name it gives . In certain situations a levy can in

reality be directed at net gain even though it is

imposed squarely on gross income . That would be the

case if it were clear that the costs, expenses, or

losses incurred in making the gain would, in all

probability, always (or almost so) be the lesser part of

the gross income . In that situation there would always

(or almost so) be some net gain remaining, and the

assessment would fall ultimately upon that profit . E- 2

In Inland Steel Co . v . United States , 230 Ct .

Cl .

314, 325,

677 F .2d 72, 80 (1982), also cited in the preamble, the Court of

Claims, relying on its earlier decision in Bank of America I,

emphasized the purpose of the foreign country in designing the tax

to reach net gain :1 3

To qualify as an income tax in the United States sense,

the foreign country must have made an attempt always to

reach some net gain in the normal circumstances in whic h

12The test the Court of Claims adopted for the creditability

of a foreign gross income tax (the virtual certainty of net gain)

is specifically incorporated in the regulations . See sec . 1 .9012(b)(4)(i), Income Tax Regs ., quoted supra .

13As the Court of Appeals for the Second Circuit stated in

Texasgulf, Inc . v . Commissioner , 172 F .3d 209, 216 (2d Cir . 1999)

(Texasgulf II), affg . 107 T .C . 51 (1996) (Texasgulf I), the

preamble to the 1983 regulations "reaffirms Inland Steel's

general focus upon the extent to which a tax reaches net gain" .

In Texasgulf II, the Court of Appeals found creditable under the

predominant character standard in the 1983 regulations a tax, the

Ontario Mining Tax, that the Court of Claims, in Inland Steel Co .

v . United States , 230 Ct . Cl . 314, 677 F .2d 72 (1982), had found

noncreditable before the promulgation of those regulations . See

discussion infra .

- 29 •the tax applies . .,* * * The label and form of the foreign,

tax is not determinative .

Bank of Am .

Commissioner ,

Natl . Trust & Sav . Association v .

61 T .C . 752, 760

opinion 538 F .2d 334

( 1974 ),

( 9th Cir . 1976 ),

cites in the preamble ,

affd . without published

the third case the Secretary

we described the analysis of the Court o f

Claims in Bank of America I as "[distilling ]"

the governing tes t

to determine whether - a foreign income - tax qualifies as a

creditable income tax within'the meaning of-section 901(b)(1) ;

i .e ., whether the tax was

profit" . That test- ,

Moreover ,

" designed to fall on some net gain or

we added , ' " is the-proper one to apply

Id .

courts have construed the 1983 regulations in a

manner consistent with the analysis in Bank-of America I . For

example, the Court of Appeals for the Second Circuit, in

Texasgulf ,

Inc . v . Commissioner ,

(Texasgulf'II ),

172 F .3d 209

( 2d Cir . 1999)

affg . 107 T . C .'-51 (1996 ) ( Texasgulf- I), considere d

the creditability of the Ontario Mining Tax

( OMT), which imposed a

graduated tax on Ontario mines to the extent that

" profit", as

defined for OMT purposes , exceeded .a statutory exemption . In

determining ." profit" for OMT purposes ,

taxpayers were allowed to

deduct "an allowance for profit in respect of processing "

(processing allowance )

in lieu of certain expenses that were

attributable to OMT gross receipts but that were not recoverable

under the tax (nonrecoverable expenses ) .

The taxpayer had

presented empirical evidence to show that ,

across the industry,

30 the processing allowance was likely to exceed nonrecoverable

expenses for the tax years at issue . In answer to the

Commissioner's objection that the taxpayer had not shown anything

more than an accidental relationship between the processing

allowance and the nonrecoverable expenses, the Court of Appeals

stated :

At bottom, the Commissioner's argument is that the type

of quantitative, empirical evidence presented in this

case is not relevant to the creditability inquiry .

However, the language of § 1 .901-2--specifically,

"effectively compensate" and "approximates, or is

greater than"--suggests that quantitative empirical

evidence may be just as appropriate as qualitative

analytic evidence in determining whether a foreign tax

meets the net income requirement . We therefore hold

that empirical evidence of the type presented in this

case may be used to establish that an allowance

effectively compensates for nonrecoverable expenses

within the meaning of § 1 .901-2(b)(4) .

Id .

at 216 (fn . ref . omitted) . The Court of Appeals concluded :

Given the large size and representative nature of the

sample considered, these statistics suffice to show that

the Tax Court did not clearly err in finding that the

processing allowance was likely to exceed nonrecoverable

expenses for the tax years at issue . Texasgulf has

therefore met its burden of proving that the predominant

character of the OMT * * * is such that the processing

allowance effectively compensates for any nonrecoverable

costs .

Id .

at 215-216 .

In reaching their decisions, both the Court of Appeals and

this Court distinguished

Inland Steel Co . v . United States ,

supra

(which held the same OMT to be noncreditable) . The former

distinguished that case on the ground that it was decided before

- 31 the promulgation of section 1 .901-2, Income Tax'Regs ., and, in

particular, . before the adoption of the rule that a foreign tax law

that "provides allowances that effectively compensate'for'nonrecovery of-* * * significant costs or expenses * * * is

considered to-permit recovery of such costs and expenses ."

Texasgulf II, 172 F .3d at 216-217 . We distinguished Inland Steel

not only on that ground but also on the ground that the case was

governed by the "predominant character" test,'which replaced the

"substantial equivalence" test under which Inland Steel .was

decided . Texasgulf I, 107 T .C . at 69-70 . . In reaching that

conclusion we stated that use of the "predominant character" and

"effectively compensates" tests represented "a change from the

history and purpose approach used in cases decided before the 1983

regulations applied a factual, quantitative approach ."

Id .

at 70 .

In Exxon Corp . v . . Commissioner , 113 T .C . 338'(1999), we

considered-the creditability of .the U .K . petroleum revenue tax

(PRT) under section 901 and the 1983 regulations . We found that a

purpose of the PRT was "to .tax extraordinary profits of oil and

gas companies relating to the North Sea ."

Id .

at 344 . With

limited exceptions, the tax base subject to PRT was gross income

relating to oil and gas recovery' activities less "all significant

costs and expenses, except interest expense" .14

Id .

at'345 . I n

14The denial of a deduction for interest was designed to

prevent the use of intercompany'-debt to avoid or minimiz e

(continued . . .)

.

- 32 lieu of an interest expense deduction, the law provided a

deduction for "uplift" . ;, i .e ., "amounts equal to 35 percent of most

capital expenditures relating to a North Sea .field" .

Id .

at 347 .

With respect to the predominant character of the tax, wefound : "The purpose, administration, and structure of PRT

indicate that PRT constitutes an income or excess profits tax in

the U .S . sense ."

Id .

at 356 . We stated that the evidence at

trial showed "that special allowances and reliefs under PRT

significantly exceed the amount of disallowed interest expense for

Exxon and other oil companies", and we quoted the testimony of the

U .K . Government official who first presented PRT to the U .K . House

of Lords for formal consideration that "`of course, this tax [PRT]

represents an excess profits tax .'"

Id .

at 357 . We rejected as

irrelevant the Commissioner's contention that a company-by-company

analysis showed that most of the companies operating in the North

Sea did not have uplift allowance greater than or equal to the

disallowed interest expense, and we agreed with Exxon that the

"PRT was designed to tax excess profits from North Sea oil,and gas

production[,] which generally were earned by major oil and gas

companies[,] which owned the largest and most . profitable fields in

the North Sea ."

Id .

at 359 . We then noted that the vast majority

of those companies "had uplift allowance in excess of nonallowe d

14(

. .continued )

liability for the tax .

338, 345 ( 1999) .

Exxon Corp .

v . Commissioner , 113 T .C .

33 interest expense ."'

Exxon Corp . v . Commissioner ,

supra at .359 .

Finally, we concluded-that "the predominant character of PRT

constitutes an excess . profits or" income . tax in the U .S . sense "

creditable under section 901 .

B .

Id . --

Arguments of'°the Parties1 .

Petitioner' .s Argument s

Petitioner argues that, given the historical development,

design, .and actual operation-of the windfall tax, it constitutes a

creditable tax on excess profits .

Petitioner rejects respondent's view that, in :determining the

creditability of the windfall tax, :we'are constrained by the text

of the statute . Rather, petitioner argues•that we may consider

extrinsic evidence of the purpose-and effect of the tax as applied

to the windfall tax companies' . As .petitioner states : "The

determination of whether a foreign,tax is designed to fall on some

net gain or profit depends on the substance, and not the form o r

15Earlier in Exxon Corp . v . Commissioner , supra at 352, in

discussing the predominant .character .standard, we made the

following observation regarding sec . 1 .901-2, . Income Tax Regs . :

The regulations * * * provide that taxes either

are or are not .to .be regarded as . income taxes in their

entirety for all persons subject to the taxes . See

sec . 1 .901-2(a),-Income Tax Regs . Respondent-does not

interpret this provision as requiring that, in order to

qualify as~an income tax, a tax in question must .

satisfy the predominant character test in its

application to all taxpayers . Rather, respondent

interprets this provision as requiring that in order to

qualify as an income tax a tax must satisfy the

predominant character test in its application to a

substantial number of taxpayers .

34 label, of the tax ." In support of its position, petitioner

relies, in large part, on the decisions of this Court in Exxon

Corp . v . Commissioner , . supra , Texasgulf I, and Phillips Petroleum

Co . v . Commissioner , 104 T .C . 256 (1995), in each of which we

considered evidence of the purpose, design, and operation of the

foreign tax in question in considering creditability .

With respect to the development and design of the tax,

petitioner offers the trial testimony of Professor Littlechild,

two members of the Andersen team (Mr . Osborne and Dr . Wales), and

an exhibit constituting Mr . Robinson's trial testimony in Entergy

Corp . v . Commissioner , T .C . Memo . 2010-197, filed today, which

also involves the creditability of the windfall tax . Petitioner

notes that Professor Littlechild's testimony establishes that he

designed the regulatory system (RPI - X) that allowed the

privatized utilities to realize the higher-than-anticipated

profits during the initial period after flotation . Petitioner

also notes that both Mr . Osborne and Dr . Wales (members of the

Andersen team who testified as experts regarding the regulatory

and political concerns that led to enactment of the windfall tax)

stated that (1) the rationale for the tax was the perceived excess

profits the privatized utilities earned during the initial period

and (2) the actual form of the tax was adopted for

- 35 "presentational" reasons .16 Mr . Robinson's testimony in Enterav is

consistent with that of Mr . Osborne and Dr-`Wal`es, and it reaches

the same principal conclusion : The intent was to tax the excess

profits of the privatized-utilities :

Petitioner also offers'the testimony of MarkBallamy (Mr .

Ballamy) and Edward Maydew (Professor Maydew) both l experts 'in

accounting, the former the"founder of a'U .K . accounting'firm, the

latter a professor of accounting, atthe University of North

Carolina . Petitioner claims that the sum and substance-of Mr .

Ballamy's testimony (which dealt with U .K . financial accountin g

-concepts under the windfall profits-tax statute) "establishes that

the windfall tax fell on the excess profits of the Windfall Ta x

Companies during their'initial periods and that all =of'these

profits represented realized profits" . `Professor Maydew testifie d

regarding U .K . and U .S . financial accounting concepts and that the

windfall tax was, in substance, a' ,tax on income, `similar i n

operation to prior U' .S .-and U .K . excess profits taxes . Petitioner

claims that Professor Maydew's testimony confirms that of Mr .

Ballamy that the U . K . and, U .•S concepts of 'realization are

fundamentally the, same, thereby satisfying the regulations '

realization requirement .

16Dr . Wales testified that, during a Nov . 6, 1996, meeting

with Gordon Brown, the Andersen team "demonstrated the'

presentational linkage that could be made between the mechanics

of the tax, * * * the underlying rationale for the tax [i .e ., a

tax on the privatized utilities' initial period excess profits]

and the popular notion of undervalue at privatisation ."

- 36 Petitioner's final expert witness was Stewart C . Myers

(Professor Myers), professor of finance at .MIT's Sloan School of

Management . Professor Myers' research and teaching focus is, in

part, on the valuation of real and financial assets . Petitioner

points to Professor Myers' testimony that the differences i n

windfall tax payments by the privatized companies cannot be

explained by differences in flotation value or by changes in value

after flotation and that the tax "operated as an excess -profits

tax, not as a tax on value, change in value or undervaluation . "1 7

17As part of his testimony, Professor Myers employed a

series of scatter plot diagrams to demonstrate that there was, at

best, a very loose relationship between the windfall tax the

privatized utilities paid and changes in their actual market

values after privatization, but very tight and direct

relationships between (1) the windfall tax payments and the

cumulative initial period earnings of those companies and (2) the

windfall tax payments and what Professor Myers determined to be

the cumulative initial period excess profits of the RECs and the

WASCs .

Professor Myers also testified that the term "value in

profit-making terms", as defined in the windfall tax statute, is

not a standard economic term or concept and it has no meaning in

any other context . Moreover, he believes that it does not

represent a true economic value of,any of the privatized

utilities ; rather, he believes that it constituted "a one-off

device created to determine tax liability ." He further

testified :

The privatized companies were valued daily on the

London Stock Exchange . The designers of the Windfall

Tax could have used stock-market values to identify

(with hindsight) the "undervaluation" of the companies

on or after their IPO dates . Instead they settled on a

formula in which the chief moving part was not value

but profits .

(continued . . .)

-'37 -

Petitioner also offered the fact testimony of Mr . . Oosthuizen ,

SWEB's treasurer during the period-` leading up .to the enactment of

the windfall tax in 1997 and, before'that, SWEB's-tax-manager .

Mr . Oosthuizen, recognized -that; . under .the windfall tax F formula,

for every po.und<that=profits were reduced in an initial period

year, SWEB,received 51 percent of that amount-back as atereduction

in its windfall tax liability . < He also was involved in 'SWEB' s

decision to .act'onthat knowledge by obtaining permission from its

auditors (and ., after an initial .obj .ection, :`Inland Revenue) to

restate its accounts for its 1994-95 fiscal year .-(the final year

of SWEB' .s initial period)'-by expensing (as ;-.a reserve) . £12 millio n

of projected tree-trimming costs ., which saved SWEB over £6 million

of projected windfall .- tax . l ,--"Petitioner also notes Mr . .

Oosthuizen's recognition that the-windfall-tax operated as an

excess profits tax . In that ;regard, Mr . °Oosthuizen testified as

follows :

In effect, the .way the tax works is to say that the

amount of profits you're allowed in any year befor e

17( . . . continued )

Professor Myers rejects respondent's argument (discussed

infra ) that value in profit-making terms, because it is

calculated using-a-reasonable price-to-earnings, multiple ., is the

product of an acceptable valuation technique . In Professor=,

Myers' view, "9 is not an accurate P/E multiple, and it is not

applied to . current or,expected"future earnings *'*°* [Therefore,]

`value-in-profit-making terms .' cannot measure the economic value

that companies could, would,'or should .have had . "

1sMr . Oosthuizen testified thata Government press release

describing the windfall tax prompted-SWEB to restate its accounts

for its 1994-95 fiscal year .

- 38 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 . That's how the tax works . It has a

definition of what is allowable profit and what is

excess profits, and it taxes the excess .

Lastly, petitioner notes that it is possible to restate the

windfall tax formula algebraically to make clear that it operates

as an excess profits tax imposed (on 27 of the 32 windfall tax

companies) at an approximately 51 .7-percent rate .19 In that

regard, petitioner points to a series of stipulations in which the

parties agree that that is in fact the case 20 In-particular,

petitioner points to the parties' stipulation that the windfall

tax formula (for companies with a full 1, .461-day initial period)

can be rewritten pursuant to the following steps (where P is the

total initial period profits and FV is the flotation value) .

Statutory Windfall Tax Formula e

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

19Mr . . Oosthuizen and Professors Maydew and Myers make the

same point .

20Respondent objects to certain of those stipulations on the

ground that the reformulations are neither ( .1) "the statutory

equivalent of the equation set forth in the [Windfall Tax] Act"

nor (2) "an appropriate application of the equation in the Act",

and on the further ground that the stipulations are "irrelevant

and immaterial ." Respondent does not object to the mathematical

equivalence of the reformulations .

- 39 , Windfall Tax Formula--Modification (1)

Tax = 23% x [{ (P/4[211) x 9 1

- FV)]

Windfall Tax Formula--Modification (2)

Tax = 51 . 71% x (P - (44 .47% x' FV) } 122

1

Petitioner also points out that, instead of a cumulative

reformulation of the windfall tax for the entire initial period,

the tax can be reformulated by showing its application with

respect to each year of that period as follows (where P1, P2, etc .

represent profits for year 1, year 2,-etc .) .

Tax = 51 .71% x {P1 - (11 .11% x FV)}

+ 51 .71% x {P2 - (11 .,11% x FV) }

+ 51 .71% x {P3 - (11 .11% x FV) }

+ 51 .7106 x { P4 - (11 .14-6' x FV) } 123 1

Petitioner argues that the foregoing mathematical and

algebraic reformulations of the windfall tax as enacted show that ,

21For the sake of simplicity here and in modification (2),

1,461 days divided by 365 days is deemed to equal 4 rather than

the more accurate 4 .0027397 .

22Again, for the sake of simplicity, 44 .47 percent

represents (1',461/365)/9 or approximately 0° .4447489 (which is

approximately 4/9), and the 51 .71 percent represents

{9/(1,461/365)•} x 23-percent or approximately 0 .5171458 (which is

approximately 9/4 of the 23-percent windfall tax rate) . As

Professor Myers points out, to get from modification (1) to

modification (2), one need only multiply all terms inside the

brackets (in modification (1)), by 4/9 and the 23 percent tax rate

by 9/4 with the windfall tax amount remaining unchanged, because

(4/9) x (9/4) = 1 .

23The 11 .14 percent reflects the multiplier for the leap

year of 366 days, assumed, for demonstrative purposes, to be year

4 .

- 40 in substance, it was a tax imposed at a 51 .71-percent rate "on the

profits for each Windfall Tax company's initial period to the

extent those profits exceeded an average annual return of

approximately 11 .1 percent of [the company's flotation value] . "

Petitioner acknowledges,-and the parties have stipulate d

(with respondent lodging the same objections regarding lack of

statutory equivalency, appropriateness, relevancy, an d

materiality), that 5 of the 32 windfall tax companies had initial

periods longer or shorter than 1,461 days and that, for those

companies, the reformulated rates are different . For two of those

companies, because the number of days in the initial period was

very close to 1,461 days, the rate of the reformulated windfall

tax was very close to 51 .71 percent, and the 4-year return on

flotation value to-be exceeded for there to be a tax was very

close to 44 .47 percent . For NIE, which had an initial period of

1,380 days, those two rates were 54 .75 percent and 42 .01 percent,

respectively . As noted supra , British Energy had no windfall tax

liability because of insufficient profits during the initial

period . The fifth company, Railtrack, had an initial period of

only 316 days, with the result that the effective tax rate on its

excess profits (determined pursuant to the stipulated

reformulation of the tax) was 239 .10 percent, and the cumulative

4-year return on flotation value to be exceeded for there to be a

tax was only 9 .62 percent . Petitioner dismisses any concerns

- 41 -

regarding-the effect of 'the ; reformulated 'windfall tax on those 5

companies as compared to its-uniform effect .. on the other 27

companies on several grounds . : (1) For 2 of the - companies,the'

differences are negligible ; .(2)'any-differences in effective rates

"are not significant or*material En evaluating the overall

incidence of the Windfall'Tax" because-the 5 companies are

outliers and, therefore,° must . be ignored-for purposes o f

determining creditability under the

section-901 regulations a s

applied by the Court of Appeals 'for the Second'Circuit in

Texasgulf II and this Court in Texasgulf 1 ;'(3) as Mr . Osborne

explained, the payment of relatively large amounts of windfall tax

by companies with initial periods, of substantially`less than 1,461

days (i .e ., NIE and"Railtrack) was not'a-problem because profits

earned over the balance of what would have .been a full 1,461-day

period (referred to by'Mr . Osborne as "out performance")-would not

be subject to the tax ; and (4) the tax did not exceed the,

realized, after-tax profits of any of the Windfall tax companies .

2 .

Respondent's Arguments `

:

Respondent argues that the 1983 regulations alone control the

creditability of-the windfall tax'-because those regulations

subsume or supersede .pribr caselaw and neither require nor permit

inquiry into the purpose underlying the enactment of a foreign tax

or the history of a foreign'taxing statute ." Applying those

'regulations to this case,-' .respondent concludes-that, 'according to

- .42 the actual terms of the windfall tax statute, the windfall tax

failed to satisfy any of the tests that a foreign tax must satisfy,

to be considered "likely to reach net gain in the normal

circumstances in which it applies" ;, i .e ., the realization, gross

receipts, and net income tests . Therefore, the windfall tax did

not have the predominant character of an income tax in the,U .S .

sense . In essence, respondent's position is that, pursuant to the

terms of the statute, the windfall tax "was not imposed upon or

after the occurrence of a realization event for U .S . tax purposes

because the * * * tax was not a direct additional tax on

previously-realized earnings . Rather, the tax was imposed on the

difference between two company values ." As a tax imposed on a

base equal to the unrealized difference between two define d

values, rather than directly on realized gross receipts reduced by

deductible expenses, respondent argues that it necessarily fails

to satisfy any of the three tests .

Respondent flatly rejects petitioner's claim that, under the

1983 regulations, we may rely on extrinsic evidence "relating to

* * * [the Windfall Tax's] purported purpose, design, and

`substance' revealed through petitioner's so-called `algebraic

reformulation' of the tax .,:' Respondent argues that Texasgulf II,

Texasgulf I, and Exxon Corp . v . Commissioner , 113 T .C . 338 (1999),

which did admit extrinsic evidence to demonstrate the

creditability of foreign taxes, should be limited to their facts ;

43

i .e ., a finding that the alternative cost allowances under

consideration in those cases,`'effectively compensated" for the

nondeductibility of certain actual expenses pursuant to the .

requirements of section 1 .901-2(b)(4)_•(i)(-B), . .income Tax Regs ., and

"do not support-the use-of_extrinsic evidence to satisfy a

requirement not found .in-the regulations ."- f

Respondent also argues that we should disregard petitioner's

algebraic,reformulations of the windfall-tax statute as merely "a

hypothetical rewrite",of the statute, which does not constitute

"`quantitative' or `empirical'3evidence?that the tax-actuall y

touched net gain, "as contemplated by .this Court in Texasgulf I or

Exxon ." That argument, like,his argument that we may not consider

extrinsic'evidence that the actual incidence of the tax was on net

income or excess profits, follows-from what appears : to be the crux

of respondent's position :,,The windfall tax is unambiguousl y

imposed on the difference between two values and, therefore, i t

cannot be a tax on,income or profit .2 4

Because for respondent ",the `substance .' . of the tax _is

revealed on the face -of the Windfall,Tax statute itself"-i .e .,

"[t]he words of the U .K . statute are the `substance' of this tax"

-he believes that-it is not necessary to look beyond those, word s

. "Respondent makes the point on , brief . . ;as follows : ",The key

evidence in this case--the Windfall Tax statute itself-explicitly provides that the Windfall Tax is imposed .on a base of

the difference between two values, and such formulation fails to

satisfy the section 901 regulations ."

44 to give them meaning . Nevertheless, he-argues that, even assuming

the intent of the Andersen team and members of Parliament might be

relevant in characterizing the nature of the windfall .tax,-their

intent is as consistent with the statute as written (i .e ., a tax

on value in excess of flotation proceeds) as it is with

petitioner's view that the windfall tax was intended as a tax on

excess profits . In support of that argument, respondent refers to

Mr . Robinson's 2000 book describing his life as a member of the

.Labour Party, entitled "The Unconventional Minister", and quotes

the following"portion of chapter 6," which describes the

development and enactment of the windfall tax :

Then in October 1996 Chris Wales had a stroke of

inspiration . Chris simply turned the whole argument on

its head : . the .problem was not that the companies had

made too much profit, nor that they had paid out too

much to shareholders and fat-cat directors, nor that

they had been treated with kid gloves by the regulators .

That was all true of course : but the genesis of the

problem was that they had been sold too cheaply in the

first place . Why not then, argued Chris, tax ..the loss

to the taxpayer which arose from the sale of these

companies at what was a knock-down price .

In further support of his position that the windfall tax was

indeed a'tax on the difference between two defined values,

respondent offers the expert testimony of Peter K . Ashton (Mr .

Ashton), . a consultant who was qualified as an expert in economics

and valuation methodologies, and Philip Baker QC (Queens Counsel ;

Mr . Baker), a U .K . tax lawyer offered as an expert in U .K . tax

legislation and the U .K . tax system :

- 45 Mr . Ashton viewed the method of computing the statutory value

in profit-making terms for each of the windfall tax companies as a

generally accepted valuation methodology, which he referred to as

the "market value multiples method for computing the equity value

of a company ." Although Mr . Ashton agreed that, in general ,

"valuation is a forward-looking proposition", he reasoned that the

windfall tax methodology of fixing value retroactively was

acceptable because the draftsmen selected a valuation date with

respect to which they had "perfect foresight of what the income is

going to be for.* * * [the windfall tax companies] that you can

plug in to the valuation formula . "

The substance of Mr . Baker's testimony was that, by its

terms, the windfall tax was for each windfall tax company a tax on

a tax base equal to the difference-between two defined values, and

that, as such, it was distinguishable from prior or existing U .K .

taxes on excess profits or capital gains .

Respondent echoes Mr . Baker's view that the windfall tax was

intentionally imposed on a tax base measured, in part, by a value

the "value in profit-making terms") derived (retrospectively )

from known initial period earnings and, for that reason,

criticizes Professor Myers' reliance on "equity value or market

capitalization value" as his standard for concluding that, in

relying on "value inprofit-making terms", the windfall tax was

not a tax on value, as that term is conventionally understood . In

- 46 respondent's view, we "need not determine whether the ProfitMaking Value formula resulted in a `realistic' valuation of the

Windfall Tax Companies in order to determine whether the Windfall

Tax is a creditable tax ." That is because, in respondent's view,

profit-making value "represented a reasonable approximation of how

the Windfall Tax Companies might-have been-valued at the time of

flotation if subsequent earnings could have been known at that

time . i2 5

25Relying on a point that the Andersen team made in a

November 1996 presentation to Gordon Brown, respondent also

argues, presumably as an alternative ground for denying a foreign

tax credit for the windfall tax, that the tax was, in substance,

a reenactment of TCGA sec . 179 (see the discussion of that

provision in note 3 of this report) ; i .e ., a retroactive tax on

the unrealized appreciation of the windfall tax companies at the

time of privatization . Respondent argues that, because the tax

necessarily fails the realization test of the 1983 regulations,

it is noncreditable . We find respondent's arguments unpersuasive

for two reasons . First, respondent's own expert, Mr . Baker,

specifically disavowed those arguments by flatly stating that the

windfall tax "was not corporation tax . It was a separate tax and

it was at the rate of 23 percent instead [of the 33 percent

corporate tax rate] ." Second, we agree with petitioner that,

even if the windfall tax had been intended as (in substance) a

reenactment of TCGA sec . 179, it would not be a tax on unrealized

appreciation ; rather it would be a tax on previously realized but

unrecognized gain and, therefore, creditable . As petitioner

points out : "the operation of section 171 TCGA and section 179

TCGA is substantively similar to the gain deferral and

recognition rules relating to intercompany transfers in our

consolidated return regulations, section 1 .1502-13, Income Tax

Regs ." Petitioner argues, however, that "[t]he Windfall Tax

statute was not designed on the basis of Section 179 TCGA .

Respondent's argument on this basis is unfounded ." We accept

what is, in effect, petitioner's concession that the windfall tax

should not be considered an income tax because it resembled, or

was a reinstatement of, TCGA sec . 179 . Therefore, we do not

decide the windfall tax issue on that ground .

- 47 C.

Analysi s

1 .

Introductio n

The parties fundamentally disagree as to what we may consider

in determining whether the windfall tax is a creditable tax for

purposes of section 901 . Respondent's view is that-we need not

(indeed, may not) consider anything other than the text of'the

windfall tax statute in determining whether that tax is an "income

tax" within the meaning of section 1 .901-2(a), Income Tax Regs .

"[B]ased on * * * the simple formula employed to levy the tax",

respondent argues, the windfall tax falls . on the difference

between two values--"Flotation Value" and "Profit-Making Value" .

It is, respondent continues, therefore a tax on value (and not on

income) . "Petitioner" ., respondent concludes, "cannot escape from

the plain language of the [windfall tax] statute . "2 6

Petitioner, points out that, under the cited regulation, it

is the "predominant character" of the foreign tax in question that

counts . To determine the predominant character of-the windfall

tax, petitioner argues that we may consider evidence beyond th e

26 "In construing a statute", respondent argues, "the

`preeminent canon of statutory interpretation requires a court to

"presume that [the) legislature says in a statute what it means

and means in a statute what . it says there ."'" (quoting BedRoc

Ltd ., LLC v . United States , 541 U .S . 176, 183 (2004) (quoting

Conn . Natl . Bank v . Germain , 503 U;.S .,249, 253-254 (1992))) .

Respondent insists that "'when the statute's language is plain,

"the sole function-of the courts"--at least where the disposition

required by the text is not absurd-"is to enforce it according to

its terms ."'" (quoting Hartford Underwriters Ins . Co .~v . Union

Planters Bank, N .A . , 530 U .S . 1, 6 (2000) (quoting United States

v . Ron Pair Enters ., Inc . , 489 U .S . 235, 241 (1989)) .

- 48 text of the statute ; viz, evidence of the design~of the tax and

its actual economic and financial effect as it applies to the

majority of the taxpayers subject to it . In support of that

argument, petitioner principally relies on three cases-this Cour t

has decided since the promulgation of the 1983 regulations :- Exxon

Corp . v . Commissioner , 113 T .C . 338 (1999), Texasgulf I, and

Phillips Petroleum Co . v . Commissioner , 104 T .C . 256 (1995) .

For the reasons that follow,, we think that petitioner has the

better argument, and we find that the windfall tax is a creditable

income tax under section 901 .

2 .

Nature of the Predominant Character Standard

Respondent's text-bound approach to determining the

creditability of the windfall-taxis inconsistent with the 1983

regulations' description of the predominant character standard for

creditability under .which "the predominant character of a foreig n

tax is that of an-income tax in the U .S . sense * * * [i]f

*

the foreign tax is likely to reach net gain in the normal

circumstances in which it applies" . Sec . 1 .901-2(a)(3)(i), Income

Tax Regs . By implicating the circumstances of application in the

determination of the predominant character of a foreign tax, th e

drafters of the 1983 regulations clearly signaled their intent

that factors extrinsic to the text of the foreign tax statute play

a role in -the determination of the tax's character . In

determining the predominant character of a foreign tax, we may

49 look to the actual effect of the foreign-,tax on taxpayers subject

to it, the inquiry being whether the tax is designed to and does,

in .fact, reach net gain "in the normal circumstances in which it

applies regardless of the form of the .foreign tax as reflected

in the statute .

That interpretation of the' regulations' predominant character

standard is .consistent with caselaw preceding the issuance of th e

1983 regulations and, in particular, two of the cases cited in th e

preamble to those regulations as .providing the "criterion fo r

creditability"

embodied in that standard : - Inland Steel Co . v .

United States , 230 . Ct . Cl . 314,- .677 F .2d 72 ( 1982 )', . . and Bank o f

America I (see supra p . 27 of this report) . In the former case,

the Court of Claims stated that a foreign tax will qualify as a n

income tax in the U .S .

sense if the foreign country has " made an .

attempt always to reach some net gain :in :the normal circumstances '

in which the tax applies . * * * The label and form of the foreign

tax is not determilnative ." . . Inland Steel Co . v . United .States ,

supra at 325, 677 F .2d at,80 (emphasis added) . The court noted

that the issue, as framed under . its analysis in Bank of America I,

is "whether taxation of . net gain is the ultimate objective or

effect of * * * [the foreign] tax ."

Inland Steel Co . v . United

States ,, supra at 1 26, 677-F .2d at-80 (emphasis added) . In Bank o f

America I, . .198 Ct .

Cl . at 274, 459 F .2d at 519 (emphasis added) ,

the Court of Claims stated : "The important thing is whether the

50 other country is attempting to reach some'net'gain,

not the form

in which .it shapes the income tax or the name it gives . "

The facts and analysis of the Court of Claims in Bank-of

America I nicely illustrate .the prevailing pre-1983 standard .- The

case involved in part the creditability of foreign taxes on the

taxpayer's gross income from the banking` business its branch

conducted in each of certain foreign countries . Clearly, a gross

income tax is not, . by its terms,a net . income tax . Had the Court

of Claims focused solely on the statutory language, which, in each

case, levied a tax on the taxpayer's "gross takings" or "gross

.receipts" before deduction of any expenses, it would have been

compelled to hold, on that ground alone, that none of the taxes

under consideration constituted .a creditable net income tax . The

focus of the court's inquiry, however, was not on the text of the

statute per se, but on the question,of whether the tax was

"attempting to reach some net gain" .

Id . : The court specifically

noted that "a levy can in reality be directed at net gain even

though it is imposed squarely on gross income ."

Id .

Relying on

prior judicial decisions, Internal Revenue Service rulings, and

gross income tax levies under Federal law (e .g ., sections 871 and

1441), the court concluded that an income tax under section 901

"covers all foreign income taxes designed to .fall .on some net gain

or-profit, and includes a gross income tax if, but only if, that

impost is almost sure, or very .likely, to reach some net gain

51 because costs or expenses will not be so high as to offset the net

profit ."

Id .

at 281, 459 F .2d at 523 .27 Because the gross income

taxes in Bank of America I failed to meet that test, the court

held that they were noncreditable .

Id .- at 283, 459 F .2d at 524-

525 .

Also, as noted supra , the cases that have applied the 1983

regulations' predominant character standard are consistent with

the Court of Claims' approach to creditability in

Inland Steel

and Bank,of America I . Thus, in Texasgulf I, and in Exxon . Corp .

v . Commissioner ,

supra,

we relied`on quantitative, empirical

evidence of the actual effect of the foreign tax on a majority of

the taxpayers at whom it was directed and found that, in each

case, the tax was designed to, and did, in fact, reach net gain

and, therefore,

.constituted a creditable income or excess profits

tax . In Texasgulf I, we distinguished the result in Inland Steel

Co . v . United States ,

supra , which had held the tax under

consideration (the Ontario Mining Tax) to be noncreditable,

stating: "The use of the `predominant character' and

`effectively compensates' tests in section 1 .901-2(b)(4), Income

Tax Regs ., is a change from the history and purpose approach used

in the cases decided before the 1983 regulations applied a

27As noted supra note 12, the Court of Claims' test for the

creditability of a gross income tax is incorporated into the 1983

regulations . See sec . 1 .901-2(b)(4)(i), Income Tax Regs .

52 -

factual, quantitative approach ." Texasgulf I, 107'T .C . at 70

(emphasis added) .

We reject respondent's argument that this Court, in

.Texasgulf -I and Exxon ,- and the Court of Appeals for the Second

Circuit, in Texasgulf II, "strictly limit the use of empirical

data to an analysis under the alternative cost recovery method of

the net income requirement of * * * [section 1 .901-2(b)(4)(i)(B),

Income Tax Regs .] ." It is true that Texasgulf I,,Texasgulf II,

and Exxon involved the creditability of foreign taxes that

started with a statutory tax base consisting of gross income, and

that all three relied on extrinsic evidence to show that the

foreign law's allowances in lieu of deductions for expenses

actually incurred would "effectively compensate for nonrecovery

of * * * significant costs or expenses", as . required by section

1 .901-2(b)(4)(i), Income Tax Regs . We disagree, however, with

respondent's conclusion that those cases "do not support the use

of extrinsic evidence to satisfy a requirement not found in the

regulations ." Nothing in those cases would-so limit a taxpayer's

right to rely on extrinsic evidence to demonstrate the

creditability of a foreign tax and, specifically, that it,

satisfied the predominant character standard . In Texasgulf I,

Texasgulf II, and Exxon , the narrow issue was whether the

statutory allowances in question did, in fact, "effectively

compensate" for the nondeductibility of "significant costs or

- 53 expenses" within the meaning of section 1 .901-2(b)(4)(i), Incom e

Tax Regs . But the overall issue for decision in those cases, as

in this case, was whether the foreign tax was designed to and

did, in fact, reach net gain . The only limitation on reliance on

extrinsic evidence in any of the three opinions in those cases is

the following observation by the Court of Appeals for the Second

Circuit in Texasgulf II, 172 F .3d at 216 n .ll :

We note, however, that this case is exceptional, in

that the relatively small number of taxpayers subject

to the OMT made it practicable to compile and present

broadly representative industry data spanning a lengthy

period . We do not suggest that the reliance that we

place on empirical evidence would be appropriate in

cases where such comprehensive data is unavailable .

Far fewer taxpayers were subject to the windfall tax than were

subject to OMT in Texasgulf II, and the data .(after-tax financial

profits 21 for the taxpayers subject to the windfall tax were

readily available in the published financial reports of those

taxpayers .

28Although respondent states that "[t]he use of financial

book earnings, rather than `taxable income,' in determining the

Windfall Tax Companies['] Profit-Making Value further

distinguishes the Windfall Tax from a U .S .-excess profits tax",

he does not argue that a foreign tax on financial profits is

noncreditable for that reason alone . That argument would appear

to be invalid, in any event, in the light of our own corporate

alternative minimum tax, which at one time was calculated, in

part, using financial or book earnings . See sec . 56(f), repealed

in 1990 by the Omnibus Budget Reconciliation Act of 1990, Pub . L .

101-508, sec . 11801(a)(3), 104` Stat . 1388-520 . Moreover,

differences between book and taxable income are, with rare

exception, attributable to timing differences, which are .

generally-disregarded under the 1983 regulations . See sec .

1 901-2(b)(4)(i), Income Tax Regs .

- 54 Respondent's argument that we should restrict our inquiry to

the text of the windfall tax to determine its predominant

character is unpersuasive .

3 .

The Predominant Character Standard as Applied to

the Windfall Ta x

The term "value" may mean, among other things, either

"Monetary or material worth" or, in mathematics, "An assigned or

calculated numerical quantity ." The American Heritage Dictionary

of the English Language

1900

(4th ed . 2000) . The parties do not

disagree that the amount of the windfall for purposes of

determining the windfall tax is, in mathematical terms, the

excess (if any) of one value (value in profit-making terms) over

another (flotation value) . Nor do they disagree that flotation

value is real or actual value (a value in the first sense) . They

do disagree as to whether value in profit-making terms is a real

or actual value . Relying on its experts' testimony, petitioner

argues that it is not "a real economic value" .29 We need not

settle that dispute because, even were we to agree with

respondent that value in profit-making terms is a real or actual

value, that would not necessarily be determinative since our

inquiry as to the predominant character of the windfall tax i s

29Mr . Osborne, one of petitioner=s expert witnesses and a

member of the Andersen team involved in designing the windfall

.tax, testified that value in profit-making terms "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, and a

mechanism by which additional taxes on profits could be levied ."

55 -

not text bound . Indeed," :,however we describe the 'form of the '

windfall tax base, our inquiry as to the design and incidence of

the tax convinces us that its predominant character is that of a

tax on excess profits . As an initial matter, we note that th e

parties have stipulated that none of-the 3 1 companies that paid

windfall tax had a windfall, tax liability in excess of its total

profits over its initial period .

With respect to design, respondent reorders the usual notion

(at least in architecture) that form follows function to argue ,

in essence, that form determines function ; i .e ., .that the desig n

of the tax base (the excess of one value over another )

demonstrates Parliament's decision to enact a tax based on valu e

(i .e ., "to tax undervaluation on flotation of the Windfall Tax

Companies") "rather than a tax based on income or exces s

profits ." We disagree .

Gordon Brown's public statements in his July 2, 1997, Budget

Speech,'the Inland Revenue and U .K . Treasury announcements, and

the debate in Parliament preceding enactment of the windfall tax

make clear that the tax was justified .for two essentiall y

equivalent reasons : (1) It would recoup excessive profits earne d

by the privatized utilities',during the-"initial period, and (2) i t

would correct for the undervaluation of those companies at

flotation . The reasons"are equivalent because each subsumes the

other . That is the essence of the explanation of the windfall

56 tax by Her Majesty's Treasury in its 1997 publication entitled

"Explanatory Notes : Summer Finance Bill 1997" :

..The profits made by these companies in the years

following privatisation were excessive when considered

as a return on the value placed on the companies at the

time of their privatisation by flotation . This i s

because the companies were sold too cheaply and .

regulation in . the relevant periods was too lax .

Thus, profits were considered excessive in relation to the prices

at which the windfall tax companies were sold to the public,

which, in turn, were deemed to be too low .30 One explanation

implies the other . It follows, then, that both parties may b e

said to be correct in their assessment of the politica l

motivation for the windfall tax .

Of greater significance, in terms of the creditability of

the windfall tax, is the fact that the members of Parliament

understood that they were enacting a tax that, by its terms,

represented one of two equivalent explanations . That

understanding is evidenced by the Conservative Party Shadow

Chancellor of the Exchequer's, Mr . Lilley's, recognition that th e

30That rather obvious point was also made by Mr . Osborne :

The rationale for the tax was rooted i n

[the] initial period during which excessive profits

were made, as judged against the companies ' flotation

values .

The nature of the judgment means that there is a .

logical symmetry between the two available ways of

describing the rationale for the tax -- that profits

were high in relation to the flotation value, or that

the flotation value was low in relation to profits .*

57 Government had "taken average profits over four years after

flotation" and "[i]f-those profits exceed one ninth of the

flotation value, the company will pay windfall tax on the

excess ." Mr . Lilly's understanding that the windfall tax coul d

be characterized as a tax on excess profits is further indicated

by his recognition that privatized utilities "that failed to

improve their profitability over * * * [the initial period]- will

pay much less or even no windfall tax . "

Just as "a levy can in reality be directed at net gain even

though it is imposed squarely on gross income", Bank of America

I, 198 Ct . Cl . at 274, 459 F .2d at 519, so too can a foreign levy

be directed at net gain or income even through it is, by its

terms, imposed squarely on the difference between two values .3 1

31A classic definition of income from the economic

literature is squarely so based : "Income is the money value of

the net accretion to one's economic power between two points of

time ." Haig, "The Concept of Income-Economic and Legal Aspects",

The Federal Income Tax 7 (Columbia University Press 1921) .

Robert M . Haig's definition was subsequently expressed by

another economist, Henry C . Simons, in a way that explicitly

included consumption : "Personal income may be defined as the

algebraic sum of (1) the market value of rights exercised in

consumption and (2) the change in value of the store of property

rights between the beginning and end of the period in questions ."

Simons, Personal Income Taxation 50 (1938) . The Simons

refinement has come to be known as the Haig-Simons definition of

income and is widely accepted by lawyers and economists . Graetz

& Schenk, Federal Income Taxation, Principles and Policies 97

(6th ed . 2009) .

A foreign tax imposed on a base conforming to the HaigSimons .definition of income, viz, (1) the value of savings at the

end of .the period .plus consumption during the period minus (2 )

(continued . . .)

- 58 And that . is what we conclude in the case of the windfall tax .

The architects and drafters of the tax knew (1) exactly which

companies the tax would target, (2) the publicly reported aftertax financial profits .of those companies, which were a crucial

component of the tax base,32 and (3) the target amount of revenue

the tax would raise . Therefore, it cannot have been an

unintentional or fortuitous result that, (1) for 29 of the 31

windfall tax companies that paid tax, the effective rate of tax

on deemed annual excess profits was at or near 51 .7 percent,33 an d

31 (

. . . continued )

the value of savings at .the beginning of the period, would seem

to qualify as a tax on net gain under the 1983 regulations . That

.the tax base includes unrealized appreciation in property is no

bar to such qualification . See sec . 1 .901-2(b)(2)(i)(C), (iv)

Example (2), Income Tax Regs .

32SWEB's ability to reduce retroactively its reported

profits for one of its initial period years appears to have been

a solitary aberration among the windfall tax companies and does

not detract from the general conclusion that the initial period

financial profits of the windfall tax companies were known before

enactment . .

33Because it had an initial period of only 316 days,

Railtrack presents the sole exception to the overall conclusion

that the windfall tax, viewed as a tax on excess profits,

affected the targeted companies in a reasonable manner . As noted

supra , the effective tax rate on Railtrack's excess profits was

239 .10 percent and the cumulative 4-year return on flotation

value to be exceeded for there to be a tax was only 9 .62 percent .

It is clear, however, that neither the regulations nor the cases

interpreting them require that the foreign tax mimic the U .S .

income tax for all taxpayers to achieve creditability under sec .

901, only that it satisfy that standard "in the normal

circumstances in which it applies" . See sec . 1 .901-2(a)(3)(i),

Income Tax Regs . See also Exxon Corp . v . Commissioner , 113 T .C .

at 352, in which we noted the Commissioner's acknowledgment that,

"to qualify as an income tax a tax must satisfy the predominan t

(continued . . .)

59 (2) for none of the 31 companies did the tax exceed total initial

period profits . What respondent refers to as "petitioner's

algebraic reformulations of the Windfall Tax statute" do not, as

respondent argues, constitute an impermissible "hypothetical

rewrite of the Windfall Tax statute" . Rather they represent a

legitimate means of demonstrating that Parliament did, in fact,

enact a tax that operated as an excess profits-tax for the vast

majority of the windfall tax companies .34 The design of the

windfall tax formula . made certain that the tax would, in fact,

operate as an excess profits tax for the vast majority of the

companies subject to it .3 5

33( . . .continued)

character test in its application to a substantial number of

taxpayers . In that case we found that the U .K . Petroleum

Revenue Tax (PRT) provided a sufficient allowance in lieu of a

deduction for interest expense where, for the 34 companies

responsible for 91 percent of the PRT payments, the allowanc e

exceeded nonallowed interest expense .

s

34 Respondent describes petitioner's algebraic reformulation

of the windfall tax as an attempt "to rewrite the value-based

Windfall Tax to convert it into a profit-based tax ." Presumably,

respondent would agree that, had the tax been enacted as a

"profit-based tax" instead of as a tax on the difference between

two values, it would have been creditable . Under that approach,

the same tax is either creditable or,noncreditable, depending on

the form in which it is enacted, a result at odds with the

predominant character standard set forth in the regulations and

applied in the caselaw .

351f, as respondent suggests, the real goal of the'windfall

tax was to recoup, on behalf of the public, the windfall to the

initial investors that arose by virtue of flotation prices well

below actual value (as perceived . with hindsight), why did the

Labour Party majority not try to recoup the entire windfall or at

least a substantial portion of it ; i .e ., why was the tax rate no t

(continued . . .)

60 Because both the design and effect of the windfall tax was

to tax an amount that, under U .S . .tax principles, may be

considered excess profits realized by the vast majority of the

windfall tax companies, we find that it did, in fact, "reach net

gain in the normal circumstances in which it [applied]", and,

therefore, that its "predominant character" was "that of an

income tax in the U .S . sense ." See sec . 1 .901-2(a)(1), (3),

Income Tax Regs .

We recognize that, in the cases that have either provided

the foundation for the predominant character standard (e .g .,

Inland Steel Co . v . United States , 230 Ct . Cl . 314, 677 F .2d 72

(1982), and Bank of America I), or applied that standard (e .g .,

Texasgulf I, Texasgulf II, and Exxon Corp . v . Commissioner , 113

T .C . 338 (1999)), the tax base, pursuant to the statute, was a

gross amount or a gross amount less expenses comprising, in part,

allowances in lieu of actual costs or expenses, and the issue was

whether the statutory tax base represented net gain for th e

3 .5 ( . . .continued )

100 percent or something closer to it than the 23-percent rate

actually imposed? Although there is no evidence in the record

that would provide a direct answer to that question, we find the

enactment of the relatively low 23-percent rate to be consistent

with an awareness of the Labour Party that it was taxing the

companies, not the investors who actually benefited from the

allegedly low flotation prices, and a decision, on its part, that

a tax on the companies, being, in effect, a second tax on their

initial period profits, should be imposed at a reasonable,

nonconfiscatory rate, which would be sufficient to raise the

desired revenue . That view is, of course, consistent with

petitioner's argument that the form of the tax was adopted for

"presentational" reasons .

61 majority of taxpayers subject to the foreign tax . Nevertheless,

the analysis that led the courts in those cases (with-the

exception of Inland Steel )36 to determine creditability or

'noncreditability of the foreign tax in issue is equally

applicable in determining the creditability of the windfall tax,

the question being whether, according to an empirical or

quantitative analysis, the tax was likely reach net gain in the

-t

normal circumstances in which it applied . Because the facts of

this case provide an affirmative answer to that question, we find

the windfall tax to be creditable .

D.

Conclusio n

The windfall tax paid by petitioner's indirect U .K .

subsidiary, SWEB, constituted an excess profits tax creditable

under section 901 .

II .

The Dividend Rescission Issu e

The parties submitted the dividend rescission issue fully

stipulated . On brief, petitioner states that, if we resolve the

windfall tax issue in its favor, then petitioner concedes the

dividend rescission issue . Because we have done so, we need no t

36AS we noted in Texasguif I, 107 T .C . at 71, the Court of .

Claims in Inland Steel Co . v . United States , 230 Ct . Cl . 314, 677

F .2d 72 (1982) "did not have industry-wide data to consider, and

the Secretary had not yet promulgated regulations using a

quantitative approach", and it held the Ontario Mining Tax to be

noncreditable because it was not the "substantial equivalent" of

an income tax, a standard for creditability that was modified by

the 1983 regulations' adoption of the predominant character

standard .

62 -

address the dividend rescission issue . We accept petitioner's

concession .3 7

III .

Conclusio n

Taking into account our prior opinion in

PPL Corp . & Subs .

v . Commissioner , 135 ., T .C ., (2010)9,

Decision will be entere d

under Rule 155 .

37Petitioner argues that if we resolve the windfall tax

issue in its favor, then SWEB Holdings would not have had

sufficient earnings, and profits to pay a taxable dividend . Any

distribution by SWEB Holdings would thus constitute a nontaxable

return of capital, .- On brief, petitioner states that the "tax

consequences [of such a nontaxable return of capital] would not ,

.in petitioner's judgment, be material ." For that reason, "[i]n

the interest of judicial economy", petitioner does not ask that

we decide the dividend rescission issue in its favor if we decide

the windfall tax issue in its favor .

- 63 APPENDI X

PP&L Resources, Inc .

Power Markets

Development Co .

(PMDC )

PMDC International

.Holdings, Inc .

PMDC UK Holdings, Inc .

PMDC Bristol, Inc .

Southern Electric

InternationalEurope, Inc .

(SEI )

250

\

75%

Southern Investments UK

Holdings Ltd . (SWEB Holdings )

Southern Investments UK plc

(SIUK )

South Western Electricity plc

(SWEB)