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SUPREME COURT OF THE UNITED STATES
_________________
No. 12–43
_________________
PPL CORPORATION AND SUBSIDIARIES, PETITION-
ERS
v. COMMISSIONER OF INTERNAL REVENUE
on writ of certiorari to the united states
court of appeals for the third circuit
[May 20, 2013]
Justice Thomas delivered the opinion of the
Court.
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
credit-able under §901 and reverse the judgment of the Court of
Appeals for the Third Circuit.
I
A
During the 1980’s and 1990’s, the U. K.’s
Conservative Party controlled Parliament and privatized a number of
government-owned companies. These companies were sold to private
parties through an initial sale of shares, known as a “flotation.”
As part of privatization, many com-panies were required to continue
providing services at the same rates they had offered under
government control for a fixed period, typically their first four
years of private operation. As a result, the companies could only
increase profits during this period by operating more efficiently.
Responding to market incentives, many of the companies became
dramatically more efficient and earned substantial profits in the
process.
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. Par-liament 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:
D equals the number of days a company was
subject to rate regulation (also known as the “initial period”), P
equals the total profits earned during the initial period, and FV
equals the flotation value, or market capitalization value after
sale. For 27 of the 32 companies subject to the tax, the number of
days in the initial period was 1,461 days (or four years). Of the
remaining five companies, one had no tax liability because it did
not earn any windfall profits. Three had initial periods close to
four years (1,463, 1,456, and 1,380 days). The last was privatized
shortly before the Labour Party took power and had an initial
period of only 316 days.
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 × (P ∕ D) × 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.
B
Petitioner PPL Corporation (PPL) was an owner,
through a number of subsidiaries, of 25 percent of South Western
Electricity plc, 1 of 12 government-owned elec-tric companies that
were privatized in 1990 and that were subject to the tax. See 135
T.C. 304, 307, App. (2010) (diagram of PPL corporate structure in
1997). South Western Electricity’s total U. K. windfall tax
burden was £90,419,265. In its 1997 federal income-tax return, PPL
claimed a credit under §901 for its share of the bill. The
Commissioner of Internal Revenue (Commissioner) rejected the claim,
but the Tax Court held that the U. K. wind- fall tax was
creditable for U. S. tax purposes under §901. See
id.,
at 342. The Third Circuit reversed. 665 F.3d 60, 68 (2011). We
granted certiorari, 568 U. S. ___ (2012), to resolve a Circuit
split concerning the windfall tax’s creditability under §901.
Compare 665 F. 3d, at 68, with
Entergy Corp. &
Affiliated Subsidiaries v.
Commissioner, 683 F.3d 233,
239 (CA5 2012).
II
Internal Revenue Code §901(b)(1) provides that
“[i]n the case of . . . a domestic corporation, the
amount of any income, war profits, and excess profits taxes paid or
accrued during the taxable year to any foreign country or to any
possession of the United States” shall be creditable.[
2] Under relevant Treasury Regulations, “[a]
foreign levy is an income tax if and only if . . . [t]he
predominant character of that tax is that of an income tax in the
U. S. sense.” 26 CFR §1.901–2(a)(1). The parties agree that
Treasury Regulation §1.901–2 applies to this case. That regulation
codifies longstanding doctrine dating back to
Biddle v.
Commissioner,
302 U.S.
573, 578–579 (1938), and provides the relevant legal
standard.
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 for-eign 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
attrib-utable to such gross receipts. A foreign tax that reaches
net income, or profits, is creditable.
III
A
It is undisputed that net income is a
component of the U. K.’s “windfall tax” formula. See Brief for
Respondent 23 (“The windfall tax takes into account a company’s
prof-its during its four-year initial period”). Indeed, annual
profit is a variable in the tax formula. U. K. Windfall Tax
Act, sched. 1, §1, cls. 2(2) and 5. It is also undisputed that
there is no meaningful difference for our purposes in the
accounting principles by which the U. K. and the U. S.
calculate profits. See Brief for Petitioners 47. The dis-agreement
instead centers on how to characterize the tax formula the Labour
Party adopted.
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
“vari-able” in the windfall tax formula except for profits and
flotation value is fixed (at least with regard to 27 of the 32
companies). 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
credit-able 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:
This formula can be rearranged algebraically to
the following formula, which is mathematically and substantively
identical:[
4]
The next step is to substitute the actual number
of days for D. For 27 of the 32 companies subject to the windfall
tax, the number of days was identical, 1,461 (or four years).
Inserting that amount for D in the formula yields the
following:
Simplifying the formula by multiplying and
dividing numbers reduces the formula to:
As noted, FV represents the value at which each
company was privatized. FV is then divided by 9, the arbitrary
“price-to-earnings ratio” applied to every company. The economic
effect is to convert flotation value into the profits a company
should have earned given the assumed price-to-earnings
ratio. See 135 T. C., at 327 (“ ‘In effect, the way the
tax works is to say that the amount of profits you’re allowed in
any year before 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’ ” (quoting testimony from the treasurer of South
Western Electricity plc)). The annual profits are then multiplied
by 4.0027, giving the total “acceptable” profits (as opposed to
windfall profit) that each company’s flotation value entitled it to
earn during the initial period given the artificial
price-to-earnings ratio of 9. This fictitious amount is finally
subtracted from
actual profits, yielding the excess profits,
which were taxed at an effective rate of 51.71 percent.
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, 39Stat. 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.
B
We find the Commissioner’s other arguments
unpersuasive as well. First, the Commissioner attempts to buttress
the argument that the windfall tax is a tax on value by noting that
some U. S. gift and estate taxes use actual, past profits to
estimate value. Brief for Respondent 17–18 (citing 26 CFR
§20.2031–3 (2012) and 26 U. S. C. §2032A). This argument
misses the point. In the case of valuation for gift and estate
taxes, past income may be used to estimate future income streams.
But, it is
future revenue-earning potential, reduced to
market value, that is subject to taxation. The windfall profits
tax, by contrast, undisputedly taxed
past, realized net
income alone.
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 in- come (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 ac-tual, 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:
“Say that the tax rate on the hypothetical
extraction tax is 20%. It is true that a 20% tax on 105% of
receipts is mathematically equivalent to a 21% tax on 100% of
receipts, the latter of which would satisfy the gross receipts
requirement. PPL proposes that we make the same move here,
increasing the tax rate from 23% to 51.75% so that there is no
multiple of receipts in the tax base. But if the regulation allowed
us to do that, the example would be a nullity.
Any tax on a
multiple of receipts or profits could satisfy the gross receipts
requirement, because we could reduce the starting point of its tax
base to 100% of gross receipts by imagining a higher tax rate.” 665
F. 3d, at 67.
The Commissioner reiterates the Third Circuit’s
argument. Brief for Respondent 37–38.
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 “faci-ally
irrelevant” to the analysis of the U. K. windfall tax, which
is based on true net income.
Entergy Corp.,
supra, at
238.[
6]
* * *
The economic substance of the U. K.
windfall tax is that of a U. S. income tax. The tax is based
on net income, and the fact that the Labour government chose to
characterize it as a tax on the difference between two values is
not dispositive under Treasury Regulation §1.901–2. Therefore, the
tax is creditable under §901.
The judgment of the Third Circuit is
reversed.
It is so ordered.