When Is a Foreign Tax Creditable Under Sec. 901?

Foreign Income & Taxpayers

The Supreme Court has granted certiorari in a Third Circuit case to resolve a circuit split and to answer the question of when a foreign tax is creditable under Sec. 901.

Background

Under Sec. 901(b)(1), taxpayers can claim a credit for “the amount of any income, war profits, and excess profits taxes paid or accrued . . . to any foreign country.” This provision was enacted in 1918, and, ever since, the meaning of the word “income” in the provision has been the subject of “long and tortuous” litigation (Bank of Am. Nat’l Trust & Sav. Ass’n, 61 T.C. 752, 759 (1974)).

Regs. Sec. 1.901-2(a)(1) combines the statutory terms, “income, war profits, and excess profits tax,” into one concept: income tax. A foreign assessment is an income tax if it has the “predominant character . . . of an income tax in the U.S. sense” (Regs. Sec. 1.901-2(a)(1)(ii)).

A foreign assessment has the predominant character of a tax if it is “likely to reach net gain in the normal circumstances in which it applies,” but is not a “soak-up” tax that is applied only if a foreign tax credit is available (Regs. Secs. 1.901-2(a)(3)(i) and (c)(1)). An assessment is “likely to reach net gain” if it meets three requirements: the realization, gross receipts, and net income requirements (Regs. Sec. 1.901-2(b)(1)). The realization requirement—a timing requirement—ensures the taxpayer has received income before being obligated to pay taxes on it. The gross receipts and net income requirements concern the tax base, i.e., the amount on which the tax is levied.

Circuit Split

In PPL Corp., the case in which the Supreme Court granted certiorari, the Third Circuit employed a mechanical test for determining whether a foreign assessment meets the regulations’ requirements to qualify as a creditable tax. The case involved the 1997 U.K. windfall profits tax on utilities that were privatized and price regulated. After privatization, the utilities’ profits were much higher than had been expected, so the British government imposed a one-time windfall profits tax.

The Third Circuit held that PPL Corp. was not eligible to claim a foreign tax credit for its payment of the windfall profits tax because the tax did not meet the gross receipts requirement of Regs. Sec. 1.901-2(b)(1). Under this subsection, a tax is creditable if, judging by its predominant character, it is imposed on the basis of gross receipts or gross receipts computed under a method that is likely to produce an amount that is not greater than fair market value. PPL argued that, after several simplifications to the formula for the windfall tax set out in the U.K. statute, the tax should be considered to be imposed on gross receipts.

The Third Circuit disagreed, finding that, after making PPL’s proposed simplifications to the formula, the tax base for the windfall tax was not gross receipts but instead was a multiple of gross receipts. PPL argued that this problem could be solved by going one step further and increasing the tax rate in the formula and lowering the tax base to gross receipts. The court refused to do this, stating that allowing a taxpayer to change the tax rate to avoid a problem with the tax base would read the gross receipts requirement out of the regulations, because any tax based on a multiple of gross receipts could be considered to satisfy the requirement by manipulating the tax rate.

The Fifth Circuit, on the other hand, used an approach that looked at the substance of the tax to hold the same U.K. tax was a creditable tax (Entergy Corp., No. 10-60988 (5th Cir. 6/5/12)). It examined the tax’s history and effect and held that when the predominant character of the tax was considered, the tax was a tax on excess profits that met the gross receipts requirement (as well as the realization and net income requirements).

Reflections

This dispute has implications beyond the narrow issue of the creditability of the U.K. windfall profits tax. Both cases raise questions about what constitutes an excess profits tax, when foreign taxes are creditable, and even how Treasury regulations should be interpreted.

The IRS argues in these cases that the terms of the U.K. statute should control the determination of the tax base and that the tax base must meet the gross receipts and net income requirements of Regs. Sec. 1.901-2(b). However, the regulations also introduce the concept of looking at the “predominant character” of the foreign assessment, which surely entails looking outside the four corners of the statute.

The IRS could avoid this problem by rewriting the regulations; instead, the Supreme Court will hopefully bring clarity to this issue.

PPL Corp., No. 11-1069 (3d Cir. 12/22/11), cert. granted, Sup. Ct. Dkt. 12-43 (U.S. 10/29/12)