Supreme Court Holds U.K. Windfall Tax Is Creditable

Petitioner PPL Corporation (PPL), part owner of a privatized U.K. company subject to the windfall tax, claimed a credit for its share of the bill in its 1997 federal income-tax return, relying on Internal Revenue Code § 901(b)(1), which states that any "income, war profits, and excess profits taxes" paid overseas are creditable against U.S. income taxes. Treasury Regulation § 1.901-2(a)(1) interprets this section to mean that a foreign tax is creditable if its "predominant character" "is that of an income tax in the U.S. sense." The Commissioner of Internal Revenue (Commissioner) rejected PPL's claim, but the Tax Court held that the U.K. windfall tax was creditable for U.S. tax purposes under § 901. The Third Circuit reversed.

Held: The U.K. tax is creditable under § 901. Pp. 4-14.

THOMAS, J., delivered the opinion for a unanimous Court. SOTOMAYOR, J., filed a concurring opinion.

In 1997, the United Kingdom (U.K.) imposed a one-time "windfall tax" on 32 U. K. companies privatized between 1984 and 1996. This case addresses whether that tax is creditable for U.S. tax purposes. Internal Revenue Code § 901(b)(1) states that any "income, war profits, and excess profits taxes" paid overseas are creditable against U.S. income taxes. 26 U.S.C. § 901(b)(1). Treasury Regulations interpret this section to mean that a foreign tax is creditable if its "predominant character" "is that of an income tax in the U.S. sense." Treas. Reg. § 1.901-2(a)(1)(ii), 26 CFR § 1.901-2(a)(1) (1992). Consistent with precedent and the Tax Court's analysis below, we apply the predominant character test using a commonsense approach that considers the substantive effect of the tax. Under this approach, we hold that the U.K. tax is creditable under § 901 and reverse the judgment of the Court of Appeals for the Third Circuit.

The U.K.'s Labour Party, which had unsuccessfully opposed privatization, used the companies' profitability as a campaign issue against the Conservative Party. In part because of campaign promises to tax what it characterized as undue profits, the Labour Party defeated the Conservative Party at the polls in 1997. Prior to coming to power, Labour Party leaders hired accounting firm Arthur Andersen to structure a tax that would capture excess, or "windfall," profits earned during the initial years in which the companies were prohibited from increasing rates. Parliament eventually adopted the tax, which applied only to the regulated companies that were prohibited from raising their rates. See Finance (No. 2) Act, 1997, ch. 58, pt. I, cls. 1 and 2(5) (Eng.) (U.K. Windfall Tax Act). It imposed a 23 percent tax on any "windfall" earned by such companies. Id., cl. 1(2). A separate schedule "se[t] out how to quantify the windfall from which a company was benefitting." Id., cl. 1(3). See id., sched. 1.

In the proceedings below, the parties stipulated that the following formula summarizes the tax imposed by the Labour Party:

 

 

The number 9 in the formula was characterized as a price-to-earnings ratio and was selected because it represented the lowest average price-to-earnings ratio of the 32 companies subject to the tax during the relevant period.¹ See id., sched. 1, § 1, cl. 2(3); Brief for Respondent 7. The statute expressly set its value, and that value was the same for all companies. U.K. Windfall Tax Act, sched. 1, § 1, cl. 2(3). The only variables that changed in the windfall tax formula for all the companies were profits (P) and flotation value (FV); the initial period (D) varied for only a few of the companies subject to the tax. The Labour government asserted that the term [365 x (P/D) x 9] represented what the flotation value should have been given the assumed price-to-earnings ratio of 9. Thus, it claimed (and the Commissioner here reiterates) that the tax was simply a 23 percent tax on the difference between what the companies' flotation values should have been and what they actually were.

The regulation establishes several principles relevant to our inquiry. First, the "predominant character" of a tax, or the normal manner in which a tax applies, is controlling. See id., at 579 ("We are here concerned only with the 'standard' or normal tax"). Under this principle, a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently. Creditability is an all or nothing proposition. As the Treasury Regulations confirm, "a tax either is or is not an income tax, in its entirety, for all persons subject to the tax." 26 CFR § 1.901-2(a)(1).

Second, the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis. See § 1.901-2(a)(1)(ii) (foreign tax creditable if predominantly "an income tax in the U. S. sense"). In Biddle, the Court considered the creditability of certain U.K. taxes on stock dividends under the substantively identical predecessor to § 901. The Court recognized that "there is nothing in [the statute's] language to suggest that in allowing the credit for foreign tax payments, a shifting standard was adopted by reference to foreign characterizations and classifications of tax legislation." 302 U.S., at 578-579. See also United States v. Goodyear Tire & Rubber Co., 493 U. S. 132, 145 (1989) (noting in interpreting 26 U.S.C. § 902 that Biddle is particularly applicable "where a contrary interpretation would leave" tax interpretation "to the varying tax policies of foreign tax authorities"); Heiner v. Mellon, 304 U.S. 271, 279, and n. 7 (1938) (state-law definitions generally not controlling in federal tax context). Instead of the foreign government's characterization of the tax, the crucial inquiry is the tax's economic effect. See Biddle, supra, at 579 (inquiry is "whether [a tax] is the substantial equivalent of payment of the tax as those terms are used in our own statute"). In other words, foreign tax creditability depends on whether the tax, if enacted in the U.S., would be an income, war profits, or excess profits tax.

Giving further form to these principles, Treasury Regulation § 1.901-2(a)(3)(i) explains that a foreign tax's predominant character is that of a U.S. income tax "[i]f . . . the foreign tax is likely to reach net gain in the normal circumstances in which it applies." The regulation then sets forth three tests for assessing whether a foreign tax reaches net gain. A tax does so if, "judged on the basis of its predominant character, [it] satisfies each of the realization, gross receipts, and net income requirements set forth in paragraphs (b)(2), (b)(3) and (b)(4), respectively, of this section." § 1.901-2(b)(1).³ The tests indicate that net gain(also referred to as net income) consists of realized gross receipts reduced by significant costs and expenses attributable to such gross receipts. A foreign tax that reaches net income, or profits, is creditable.

The Third Circuit, following the Commissioner's lead, believed it could look no further than the tax formula that the Parliament enacted and the way in which the Labour government characterized it. Under that view, the windfall tax must be considered a tax on the difference between a company's flotation value (the total amount investors paid for the company when the government sold it) and an imputed "profit-making value," defined as a company's "average annual profit during its 'initial period' . . . times 9, the assumed price-to-earnings ratio." 665 F. 3d, at 65. So characterized, the tax captures a portion of the difference between the price at which each company was sold and the price at which the Labour government believed each company should have been sold given the actual profits earned during the initial period. Relying on this characterization, the Third Circuit believed the windfall tax failed at least the Treasury Regulation's realization and gross receipts tests because it reached some artificial form of valuation instead of profits. See id., at 67, and n. 3.

In contrast, PPL's position is that the substance of the windfall tax is that of an income tax in the U.S. sense. While recognizing that the tax ostensibly is based on the difference between two values, it argues that every "variable" in the windfall tax formula except for profits and flotation value is fixed (at least with regard to 27 of the 32companies). PPL emphasizes that the only way the Labour government was able to calculate the imputed "profit-making value" at which it claimed companies should have been privatized was by looking after the fact at the actual profits earned by each company. In PPL's view, it matters not how the U.K. chose to arrange the formula or what it claimed to be taxing, because a tax based on profits above some threshold is an excess profits tax, regardless of how it is mathematically arranged or what labels foreign law places on it. PPL, thus, contends that the windfall taxes it paid meet the Treasury Regulation's tests and are creditable under § 901.

We agree with PPL and conclude that the predominant character of the windfall tax is that of an excess profits tax, a category of income tax in the U.S. sense. It is important to note that the Labour government's conception of "profit-making value" as a backward-looking analysis of historic profits is not a recognized valuation method; instead, it is a fictitious value calculated using an imputed price-to-earnings ratio. At trial, one of PPL's expert witnesses explained that "'9 is not an accurate P/E multiple, and it is not applied to current or expected future earnings.'" 135 T.C., at 326, n. 17 (quoting testimony). Instead, the windfall tax is a tax on realized net income disguised as a tax on the difference between two values, one of which is completely fictitious. See App. 251, Report ¶ 1.7 ("[T]he value in profit making terms described in the wording of the act . . . 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").

The substance of the windfall tax confirms the accuracy of this observation. As already noted, the parties stipulated that the windfall tax could be calculated as follows:

 

 

 

 

 

 

 

 

The rearranged tax formula demonstrates that the windfall tax is economically equivalent to the difference between the profits each company actually earned and the amount the Labour government believed it should have earned given its flotation value. For the 27 companies that had 1,461-day initial periods, the U.K. tax formula's substantive effect was to impose a 51.71 percent tax on all profits earned above a threshold. That is a classic excess profits tax. See, e.g., Act of Mar. 3, 1917, ch. 159, Tit. II, § 201, 39 Stat. 1000 (8 percent tax imposed on excess profits exceeding the sum of $5,000 plus 8 percent of invested capital).

Of course, other algebraic reformulations of the windfall tax equation are possible. See 665 F. 3d, at 66; Brief for Anne Alstott et al. as Amici Curiae 21-23 (Alstott Brief).The point of the reformulation is not that it yields a particular percentage (51.75 percent for most of the companies). Rather, the algebraic reformulations illustrate the economic substance of the tax and its interrelationship with net income.

The Commissioner argues that any algebraic rearrangement is improper, asserting that U.S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt. Brief for Respondent 28. As a result, the Commissioner claims that the analysis begins and ends with the Labour government's choice to characterize its tax base as the difference between "profit-making value" and flotation value. Such a rigid construction is unwarranted. It cannot be squared with the black-letter principle that "tax law deals in economic realities, not legal abstractions." Commissioner v. Southwest Exploration Co., 350 U.S. 308, 315 (1956). Given the artificiality of the U.K.'s method of calculating purported "value," we follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.

The Commissioner contends that the U.K. was not trying to establish valuation as of the 1997 date on which the windfall tax was enacted but instead was attempting to derive a proper flotation valuation as of each company's flotation date. Brief for Respondent 21. The Commissioner asserts that there was no need to estimate future income (as in the case of the gift or estate recipient) because actual revenue numbers for the privatized companies were available. Ibid. That argument also misses the mark. It is true, of course, that the companies might have been privatized at higher flotation values had the government recognized how efficient -- and thus how profitable -- the companies would become. But, the windfall tax requires an underlying concept of value (based on actual ex post earnings) that would be alien to any valuer. Taxing actual, realized net income in hindsight is not the same as considering past income for purposes of estimating future earning potential.

The Commissioner's reliance on Example 3 to the Treasury Regulation's gross receipts test is also misplaced. Id., at 37-38; 26 CFR § 1.901-2(b)(3)(ii), Ex. 3. That example posits a petroleum tax in which "gross receipts from extraction income are deemed to equal 105 percent of the fair market value of petroleum extracted. This computation is designed to produce an amount that is greater than the fair market value of actual gross receipts." Ibid. Under the example, a tax based on inflated gross receipts is not creditable.

The Third Circuit believed that the same type of algebraic rearrangement used above could also be used to rearrange a tax imposed on Example 3. It hypothesized:

There are three basic problems with this approach. As the Fifth Circuit correctly recognized, there is a difference between imputed and actual receipts. "Example 3 hypothesizes a tax on the extraction of petroleum where the income value of the petroleum is deemed to be . . . deliberately greater than actual gross receipts." Entergy Corp., 683 F. 3d, at 238. In contrast, the windfall tax depends on actual figures. Ibid. ("There was no need to calculate imputed gross receipts; gross receipts were actually known"). Example 3 simply addresses a different foreign taxation issue.

The argument also incorrectly equates imputed gross receipts under Example 3 with net income. See 665 F. 3d, at 67 ("[a]ny tax on a multiple of receipts or profits"). As noted, a tax is creditable only if it applies to realized gross receipts reduced by significant costs and expenses attributable to such gross receipts. 26 CFR § 1.901-2(b)(4)(i). A tax based solely on gross receipts (like the Third Circuit's analysis) would be noncreditable because it would fail the Treasury Regulation's net income requirement.

Finally, even if expenses were subtracted from imputed gross receipts before a tax was imposed, the effect of inflating only gross receipts would be to inflate revenue while holding expenses (the other component of net income) constant. A tax imposed on inflated income minus actual expenses is not the same as a tax on net income.⁵

For these reasons, a tax based on imputed gross receipts is not creditable. But, as the Fifth Circuit explained in rejecting the Third Circuit's analysis, Example 3 is "facially irrelevant" to the analysis of the U.K. windfall tax, which is based on true net income. Entergy Corp., supra, at 238.⁶

The judgment of the Third Circuit is reversed.

It is so ordered.

² Prior to enactment of what is now § 901, income earned overseas was subject to taxes not only in the foreign country but also in the United States. See Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932). The relevant text making "income, war-profits and excess-profits taxes" creditable has not changed since 1918. See Revenue Act of 1918, §§ 222(a)(1), 238(a), 40 Stat. 1073, 1080.

³ The relevant provisions provide as follows:

"A foreign tax satisfies the realization requirement if, judged on the basis of its predominant character, it is imposed -- (A) Upon 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." 26 CFR § 1.901-2(b)(2)(i).

"A foreign tax satisfies the gross receipts requirement if, judged on the basis of its predominant character, it is imposed on the basis of -- (A)Gross receipts; or (B) Gross receipts computed under a method that is likely to produce an amount that is not greater than fair market value."§ 1.901-2(b)(3)(i).

"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 (including significant capital expenditures) attributable, under reasonable principles, to such gross receipts; or (B) Recovery of such significant costs and expenses computed under a method that is likely to produce an amount that approximates, or is greater than, recovery of such significant costs and expenses." § 1.901-2(b)(4)(i).

⁴ The rearrangement requires only basic algebraic manipulation. First, because order of operations does not matter for multiplication and division, the formula is rearranged to the following:

 

 

⁵ Mathematically, the Third Circuit's hypothetical was incomplete. It should have been:

⁶ An amici brief argues that because two companies had initial periods substantially shorter than four years, the predominant character of the U.K. windfall tax was not a tax on income in the U.S. sense. See Alstott Brief 29 (discussing Railtrack Group plc and British Energy plc). The argument amounts to a claim that two outliers changed the predominant character of the U.K. tax. See 135 T.C. 304, 340, n. 33 (2010) (rejecting this view).

The Commissioner admitted at oral argument that it did not preserve this argument, a fact reflected in its briefing before this Court and in the Third Circuit. See Tr. of Oral Arg. 35-36; Opening Brief for Appellant and Reply Brief for Appellant in No. 11-1069 (CA3). We therefore express no view on its merits.

The Court's conclusion that the windfall tax is a creditable excess profits tax under 26 U.S.C. § 901(b)(1) depends on two interrelated analytic moves: first, restricting the "predominant character" analysis to those companies that shared an "initial period" of rate regulation of 1,461 days; and second, treating the tax's initial period variable as fixed. See ante, at 9-10. But there is a different way of looking at this case. If the predominant character inquiry is expanded to include the five companies that had different initial periods, especially those with much shorter initial periods, it becomes impossible to rewrite the windfall tax as an excess profits tax. Instead, it becomes clear that the windfall tax is functionally a tax on value. But because the Government took the position at oral argument that the predominant character inquiry should disregard such "outlie[r]" companies, see Tr. of Oral Arg. 38-39, and this argument is therefore only pressed by amici, Brief for Anne Alstott et al. as Amici Curiae 28-30 (hereinafter Alstott Brief), I reserve consideration of this argument for another day and another context and join the Court's opinion.

Importantly, though, the relevant Treasury Regulations also provide that a foreign tax "is or is not an income tax, in its entirety, for all persons subject to the tax." 26 CFR § 1.901-2(a)(1). One way to understand this language is that for a tax to be classed as a creditable income tax, its predominant character must be that of an income tax with respect to "all persons subject to the tax." Of course, among the many persons subject to a tax, some may face tax burdens different from the majority of affected taxpayers. The challenge in applying predominant character analysis will sometimes lie in determining whether and how such outlier taxpayers affect the characterization of a given tax.¹

The windfall tax at issue here exemplifies this problem. As the Court notes, ante, at 2-3, the parties stipulated to the following form of the windfall tax:

 

 

But not all of the 32 affected companies had an initial period length of 1,461 days; 5 of the companies had different initial periods. See App. 34, 39-41. When these different initial period values are inserted into the formulation proposed by PPL, two results follow. First, these companies have tax rates different from the 51.71% rate the Court calculates for the 27 other companies. Second, their excess profits threshold also varies.

For example, consider Railtrack Group, a clear outlier with an initial period of 316 days. Inserting this value into the stipulated formula yields the following:

 

 

Once these outlier companies are included in the creditability analysis, it becomes clear that the windfall tax "is not an income tax . . . for all persons" subject to it. 26 CFR § 1.901-2(a)(1) (emphasis added). A typical income tax applies a fixed percentage rate to a base income that varies across taxpayers. An excess profits tax does the same, but incorporates a threshold, which may or may not vary across taxpayers, to exempt a portion of the base from taxation. In contrast, here both of the rate and threshold components vary from company to company according to the D variable.³

Seen through this lens, the windfall tax is really a tax on average profits. See Alstott Brief 28-30. Under the parties' stipulated form of the windfall tax, each company pays a fixed tax rate of 23% on a base that is calculated by first multiplying a company's daily average profits during its initial period (i.e., (P/D), or total profits over the initial period divided by the length of the initial period) by a fixed price-to-earnings ratio; and then subtracting that company's flotation value (FV). See ante, at 2. In practice, this means that, for example, a company that earns $100 million over 1,461 days would pay approximately the same amount of taxes as a company that has earned $25 million over 365 days. These two companies would have almost the same average profits. See Alstott Brief 28. This is not how an income tax works.

The difference between a tax on profits and tax on average profits is especially significant for properly characterizing a tax such as the windfall tax. Average daily profits multiplied by a price-to-earnings ratio, rather than being a way of approximating income, is a way of approximating value.⁴ See Thompson, A Lawyer's Guide to Modern Valuation Techniques in Mergers and Acquisitions, 21 J.Corp. L. 457, 532-533 (1996) (describing similar valuation techniques using price-to-earnings ratios). Accordingly, incorporating an outlier like Railtrack Group into the predominant character analysis suggests that the windfall tax is a tax on a company's value. Railtrack Group and the companies like it are not random outliers, Brief for Petitioners 38, n. 3, but instead are critical pieces of data for understanding how the tax actually functioned as a matter of "economic realit[y]." Commissioner v. Southwest Exploration Co., 350 U.S. 308, 315 (1956).

This argument, however, rests on the premise that because the relevant regulations state that "a tax either is or is not an income tax, in its entirety, for all persons subject to the tax," 26 CFR § 1.901-2(a)(1)(ii), a tax's predominant character must be as an income tax for all taxpayers. But if a tax only needs to be an income tax for "a substantial number of taxpayers" and does not have to "satisfy the predominant character test in its application to all taxpayers," Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), then this average profits argument cannot get off the ground. Under this reading, the regulations tell courts to treat outliers like Railtrack Group as flukes.

At oral argument, the Government apparently rejected the notion that "outliers" like Railtrack Group are relevant to creditability analysis. See Tr. of Oral Arg. 35-39. The Government also did not argue these outliers' relevance before the Court of Appeals, ante, at 14, n. 6, and so this argument, and the regulatory interpretation it depends upon, has only been presented to this Court by amici, see Alstott Brief 17-18, 28-30. We are not barred from considering statutory and regulatory interpretations raised in an amicus brief, but we should be "reluctant to do so," Davis v. United States, 512 U.S. 452, 457, n. (1994), when the issue is one of first impression and the Federal Government has staked out what appears to be a contrary position. Thus, while I find this argument persuasive, I do not base my analysis of this case on it and therefore concur in the Court's opinion.

² The figures for the other four companies are as follows: Powergen plc, which had an initial period of 1,463 days had a tax rate of 51.64% and an excess profits threshold of 44.54%, App. 38-39; National Power plc, which had an initial period of 1,456 days, had a rate of 51.89% and a threshold of 44.32%, id., at 39-40; Northern Ireland Electricity plc, which had an initial period of 1,380 days, had a rate of 54.75% and a threshold of 42.01%, id., at 40; and British Energy plc, which had an initial period of 260 days, had a rate of 290.60% and a threshold of7.91%, id., at 34. British Energy, however, did not end up having any windfall tax liability. Id., at 33.

³ At oral argument, PPL contended that an excess profits tax in which the excess profits threshold varies according to market capitalization would also have an effective tax rate that varies across taxpayers but remains creditable. Tr. of Oral Arg. 26-27. That might be true, but that does not describe the situation here. In PPL's hypothetical, any shift in the effective tax rate depends on the profits threshold; Here, under PPL's version of the windfall tax, both the effective tax rate and the profits threshold move proportionately to a company's initial period length.

⁴ Petitioners suggested at oral argument that because some of the outlier taxpayers may have been subject to a more favorable regulatory regime in the wake of their privatization, their outsized tax rates are less meaningful because they could recoup their windfall tax burdens. See id., at 16-17. Even accepting the premise of this argument, it still does not change that fact that in "substance," ante, at 9, the tax functioned as value tax for these companies.