Last week the Fifth Circuit parted ways with the Third Circuit over the question of whether the U.K.'s "Windfall Tax" constitutes a creditable foreign income tax under I.R.C. § 901, 26 U.S.C. § 901 (thanks to reader Todd Butler for bringing this to my attention). In Entergy Corporation v. CIR, the Fifth Circuit, in an opinion by Chief Judge Edith Jones, held that Entergy is indeed entitled to its foreign income tax credit due to a subsidiary's payment of the Windfall Tax in the U.K. (the dispute concerned taxable years 1997-98; the Fifth Circuit affirmed the decision of the Tax Court in this matter). I agree with Judge Jones' reasoning; I hope other circuits follow suit. Here is the explanation of their rejection of the Third Circuit's ruling on a similar case:
The Commissioner essentially urges that because Parliament computed the Windfall Tax based on “profit-making value,” calculated according to average profits over an initial period, the tax is not designed to reach gross receipts, even though the tax may be based on gross receipts in some indirect way. But we are persuaded by the Tax Court’s astute observations as to the Windfall Tax’s predominant character: the tax’s history and practical operation were to “claw back” a substantial portion of privatized utilities’ “excess profits” in light of their sale value. These initial profits were the difference between the utilities’ income from all sources less their business expenses — in other words, gross receipts less expenses from those receipts, or net income. The tax rose in direct proportion to additional profits above a fixed (and carefully calculated) floor. That Parliament termed this aggregated but entirely profit-driven figure a “profit-making value” must not obscure the history and actual effect of the tax, that is, its predominant character.
Following oral argument in this case, however, the Third Circuit concluded to the contrary: that the Windfall Tax fails at least the gross receipts requirement of the governing regulation, 26 C.F.R. § 1.901-2(a), and is therefore not a creditable foreign income tax. PPL Corp. v. Comm’r, 665 F.3d 60, 65-66 (3d Cir. 2011). It regarded the Appellee taxpayer’s mathematical reformulation, demonstrating the Windfall Tax equated to a 51.75% tax on initial period profits, as a “bridge too far,” requiring that court to “rewrite the tax rate” to find the Windfall Tax creditable. The Third Circuit accepted that perhaps the Windfall Tax reached 23% of 2.25 times the companies’ initial period profits, but it viewed this as fatal to the gross receipts requirement. Since a tax must be established on the basis of no more than 100% of gross receipts, the Third Circuit reasoned, a tax imposed on 23% of 225% of profits could not satisfy the regulatory requirement. The Third Circuit viewed Example 3 of 26 C.F.R. § 1.901-2(b)(3)(ii), disallowing a theoretical credit for a tax based on 105% the value of extracted petroleum, as bolstering its conclusion: “[i]f 105% of gross receipts (barely more than actual receipts) does not satisfy the requirement, then 225% is in the same boat but another ocean.” That court reversed the Tax Court’s judgment.
This reasoning exemplifies the form-over-substance methodology that the governing regulation and case law eschew. The gross receipts requirement ensures a creditable income tax is usually computed “begin[ning] from actual gross receipts, rather than notional amounts.” BITTKER & LOKKEN at ¶ 72.1. This distinction between “actual receipts” and “notional amounts” reflects a core requirement in Section 1.901-2 that creditable foreign taxes must be based on either actual income or an imputed value not intended to reach more than actual gross receipts. (internal citations omitted).
- Dru Stevenson