# 135 T .C . . .No . 1 5 > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A344034d0229368a5 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text 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 subsidiary, but which, within a few days, the subsidiary rescinded and petitioner repaid (the dividend rescission issue), and (3) denied depreciation deductions that petitioner's U .S .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