H. Jacob Lager

Circuit Split Alert! – Fifth Circuit Diverges from Third in Holding UK Windfall Tax Creditable

In Court decisions, Foreign taxes on June 12, 2012 at 8:59 am

It’s a tax blogger’s dream.  In Entergy Corp. v. Commissioner, The Fifth Circuit just held on June 5 that a US company’s UK windfall tax payment qualifies as a creditable foreign tax and creates a circuit split after the Third Circuit recently held otherwise.

What’s a Windfall Tax?

In 1997 the United Kingdom enacted a windfall tax on the excess profits of certain recently privatized utility companies.  The tax was meant to address public backlash against what was perceived as bargain sales of the utilities.

The tax imposed on each of the utilities a 23 percent assessment on the difference between: (1) a company’s “profit-making value” (its average annual per day profit multiplied by nine) and (2) its “flotation value” (the price for which it was acquired).

Here, the US taxpayer who owned a UK subsidiary that operated a privatized utility paid the windfall tax and sought a US income tax credit based on that payment.  The IRS disallowed the credit.  As the Eighth Circuit noted, the parties “essentially disagreed on whether the Windfall Tax . . . constituted a tax on excess profits, creditable under I.R.C. § 901, or a tax on unrealized value” for which no credit would be allowed.

What this Means – Foreign Tax Credit Defined

In general, regulation 1.901-2(a) allows a credit only for foreign taxes the “predominant character” of which is an income tax in the US sense. To have that character, the tax must:  (1) reach only realized income, (2) be imposed on the basis of gross receipts, and (3) target only net income.

Third Circuit/IRS Position

In a previous case, the Third Circuit held that the windfall tax did not meet the second requirement – that it be imposed on gross receipts, or an amount not greater than gross receipts. According to this argument, the windfall tax statute focuses on “profit-making value,” an average profits calculation based on a particular time period, not “gross receipts,” even though gross receipts may impact the tax indirectly.

Fifth Circuit/Taxpayer Position

The Fifth Circuit court rejected the Third Circuit’s approach and, more pointedly, the notion that it must only examine the windfall statute’s text in reaching its conclusion.  Instead the panel examined the tax’s history and actual effect of the foreign tax on taxpayers.  Noting that “both the design and effect of the windfall tax was to tax an amount that, under US tax principles, may be considered excess profits realized by the vast majority of the windfall tax companies,” the panel ruled that the tax was designed to reach net gain under normal circumstances.  In practice, the taxpayer demonstrated that the windfall tax’s application would be based on “either actual income or an imputed value not intended to reach more than actual gross receipts.”  Consequently, the tax’s “predominant character” was that of the US income tax and that it was a creditable foreign tax under section 901.

At the moment, it’s unclear whether the split will reach the Supreme Court for final determination.  The essence of the clash lies in how an unconventional foreign tax might satisfy the three-prong test for US credit-worthiness.  While the issue may not be headline-grabbing like a civil rights or due process dispute, the US tax response to more exotic foreign taxes that are not easily categorized represents a real cost to US-based multinationals (this case involved a credit of $243 million).  I would guess we’ll see this up for certiorari sooner than later.


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