The Creditability of Foreign Taxes: Form vs. Substance

By Brett R. Wilkinson, Ph.D., and Katherine Wilkinson, Ph.D.




  • Sec. 901 permits a foreign tax credit for foreign “income, war profits, and excess profits taxes.” Much controversy has arisen over the years about what qualifies as a creditable tax—the IRS has adopted a narrow, form-driven interpretation of what is an income tax in its regulations.
  • The U.S. Supreme Court, in PPL Corp., decided that a British “windfall tax” qualified as a creditable tax. The Court looked to the “predominant character” of the tax and whether it was “economically equivalent” to a tax on excess profits and concluded that it was, rejecting the IRS’s approach of determining whether a tax is creditable based on the form of the tax rather than its substance.
  • It remains uncertain, based on the decision in PPL Corp., whether the IRS will reverse its position and amend the regulations to adopt a substance-over-form approach to determining if a foreign tax is a creditable income tax.

The U.S. Supreme Court’s recent decision in PPL Corp 1 is a significant development in determining which foreign taxes are creditable against U.S. income tax. U.S. law allows taxpayers to claim a credit for foreign income, war profits, and excess profits taxes paid or accrued. The specific purpose of the credit is to mitigate the risk of double taxation that would otherwise impede international business activity.

The caveat, however, is that credits are allowed only for foreign taxes that are similar to the U.S. income tax, which makes sense because there is a risk of double taxation only when foreign taxes duplicate U.S. income tax. The problem for taxpayers and the IRS is how to decide whether a foreign tax is sufficiently similar to U.S. income tax to warrant allowing a foreign tax credit. Since 1983, Treasury regulations have provided guidelines for determining whether a foreign tax qualifies. Historically, however, the IRS has adopted a hard line (and very legalistic) stance in applying these guidelines.

Experts have accused the IRS of openly adopting a “form over substance” approach to determining which foreign taxes qualify. 2 The IRS’s approach unduly disqualifies taxes that are substitutes for the U.S. income tax from being creditable. It makes little sense to disallow a credit (and thus expose taxpayers to double taxation) simply because a foreign tax does not conform to a particular pattern but has the same ultimate effect as U.S. income tax.

In 2010, PPL Corp. challenged the IRS’s form-over-substance approach and prevailed in the Tax Court, 3 which many commentators celebrated, 4 but the Third Circuit 5 sided with the IRS, embracing the notion that a foreign tax must meet the regulations’ strict form. The U.S. Supreme Court, however, concluded that the emphasis should be on the substance of the foreign levy and not simply the form. In fact, the Supreme Court was willing to rearrange the foreign tax formula to demonstrate that the tax was economically equivalent to an excess profits tax—a clear rejection of the legalistic approach the IRS favors. Taxpayers now have a much stronger basis for believing that the IRS will be forced to alter its approach.

This article examines the implications of the Supreme Court’s PPL decision, arguing that the Court’s decision highlights the flaws in the regulations many tax experts have previously identified. Nonetheless, the Court’s decision may not be sufficient to resolve the problem, and Congress or Treasury may have to fix these flaws. The Supreme Court’s decision has provided the necessary rationale for Congress or Treasury to take action.

The Foreign Tax Credit as a Solution to Double Taxation

Most governments view double taxation of the same income as undesirable, and many therefore allow a tax credit for taxes paid to other governments on foreign-source income. The United States falls within this group. The challenge for the U.S. government is to ensure that taxpayers are relieved of double taxation but are not permitted to credit nontax expenses (such as mineral royalties) or taxes that are not based on income (such as wealth taxes or gross receipts taxes) against their U.S. income tax liability.

To achieve this end, Congress enacted Sec. 901, which specifically restricts the foreign tax credit to foreign “income, war profits, and excess profits taxes.” The problem, however, lies in defining what is an income tax. In Biddle , 6 the Supreme Court pointed out that the reference point should not be the language of the foreign tax law itself but rather “whether it is the substantial equivalent of payment of the tax as those terms are used in our own statute.” The task of clarifying the meaning of Sec. 901 and setting standards for comparing a foreign levy to U.S. income taxes has been left to the regulations.

Income Tax Defined

Regs. Sec. 1.901-2 defines a foreign levy as an income tax if it meets two specific conditions. First, it must be a tax, and second, its predominant character must be an income tax in the U.S. sense, which means it “is likely to reach net gain in the normal circumstances in which it applies.” 7

Reaching net gain requires that a tax meet three requirements: (1) There must be a realization of income event (realization), (2) the starting point for measuring the tax base must be gross receipts (gross receipts), and (3) reasonable expenses must be deducted from gross receipts in figuring the tax base (net income). The IRS has applied these requirements in a very mechanical way, which is the root cause of taxpayers’ concern.

One Example: The Cash Flow Tax

In 1998, Charles E. McLure Jr. and George R. Zodrow, economics professors who had been advisers to the Bolivian government, 8 documented their concerns about the IRS’s interpretation of the requirements for meeting the net income requirement. The Bolivian government was contemplating adopting a cash flow tax, which it later abandoned in favor of a more traditional income tax, specifically because of the IRS’s opposition to allowing foreign tax credits for cash flow taxes.

McLure and Zodrow provide compelling evidence that the proposed Bolivian tax was economically equivalent to an excess profits tax and thus should have been creditable under Sec. 901. The IRS resisted because the cash flow tax included the proceeds of borrowed amounts in the tax base even though the base also allowed corresponding deductions when loan proceeds were repaid. Nonetheless, the IRS stated that its “concern was for form (whether the [cash flow tax] met the mechanical tests specified in the §901 regulations) rather than the economic substance of the [cash flow tax] system viewed as a logically consistent whole.” According to the IRS, including the loan proceeds in the tax base was clearly inconsistent with the realization requirement and thus the tax was not creditable.

The U.K. Windfall Tax

The same form-over-substance issue arose again in the recent PPL case about the creditability of the U.K.’s windfall tax, which applied specifically to 32 government-owned public utilities that the U.K. government had sold to the public between 1984 and 1996. According to the facts presented before the Tax Court, the U.K. public believed that privatization of the utilities had not conferred the much-anticipated public benefits, but instead benefited the private interests that bought the utilities in the form of excess profits and excessive executive and director remuneration.

To claw back some of this benefit for the public, the newly elected Labour government imposed the windfall tax. Unfortunately, the wording of the tax made it relatively unclear as to exactly what was being taxed. Was it the excess profits that the privatized utilities earned? Or was it simply the value the public lost because the privatized utilities’ stock was underpriced at the time of sale?

To understand the source of the confusion, the first step is to look at the windfall tax formula. The windfall tax applied a rate of 23% to a base equal to a company’s “value of a disposal in profit-making terms” less its flotation value (i.e., the total amount investors paid for the company when the government sold it). This base calculation strongly implies a tax based on a difference between two values. The problem, however, arises in determining how the law calculated the “value of a disposal in profit-making terms.” The U.K. government defined this amount as the total profits earned in the post-privatization period (generally 1,461 days, or four years), divided by 1,461, and multiplied by 365. In effect, this is the average profits in the post-privatization period on an annualized basis. This number was then multiplied by a price-to-earnings (P/E) ratio of nine.

As the former treasurer of South Western Electricity (PPL’s indirect U.K. subsidiary) noted, and both the Tax Court and Supreme Court cited, this formula meant that an entity faced a windfall tax obligation only if it earned average annual profits that exceeded one-ninth of its flotation value. Imagine an original flotation value of $100 and annual profits of $11.1 (one-ninth of the flotation value). The tax base in this case would be zero [(9 × $11.1) – $100]. When the tax is conceived in these terms, it appears more clearly to be based on excess profits (i.e., earnings above one-ninth of the flotation value) than a difference in values.

Mathematically, the petitioner went on to show that the tax formula can be rearranged as a 51.71% tax on excess profit earned in the post-privatization period, where P is the total post-privatization profit (measured over a four-year period; the total days in four years being 1,461) and FV is the flotation value.

Windfall Tax = 23% × [(365 × [P ÷ 1,461] × 9) – FV]

This collapses to 23% × [(9P ÷ 4.0027) – FV] or 23% × (2.2484P – FV)

This can be rearranged as: 51.71% × (P – 0.4447FV)

In effect, the tax is equal to 51.71% of the total profits that exceed 44.47% of the flotation value, which meets the general understanding of an excess profits tax (that is, a tax on profits above the deemed normal level of return; here a normal return equals 44.47% of the flotation value).

Back to the Regulations and the Form-Over-Substance Debate

As noted earlier, the IRS emphasized the form rather than the substance of a tax. Consistent with this approach, the IRS argued that the windfall tax was a tax on value, which failed all three of the requirements (realization, gross receipts, and net income) of the regulations. Although the Tax Court sided with the taxpayer and looked at the substance of the tax, the IRS found a sympathetic ear in the Third Circuit Court of Appeals.

The Third Circuit was particularly concerned about the realization test because the tax was based on an unrealized value and about the gross receipts test. In applying the gross receipts test, the court was unwilling to rearrange the formula to show the tax rate at 51.75% (in the court’s calculation) of profits over 44% of the flotation value . Rather, it emphasized the formula as shown: 23% × (2.25P – FV). 9 Even though these formulas are mathematically equivalent, the court was concerned that the tax was being applied to a multiple of total profits (2.25 × P) rather than to total profits (P) itself. Viewed this way, the tax fails the gross receipts test because its starting point is an inflated gross receipts amount.

It appears that the Third Circuit missed the point that an excess profits tax should be applied not to P, but rather to P less some threshold amount representing a normal return. If the court had understood this point, it would presumably have been willing to see that 2.25P less FV is in fact the same thing as P – [FV ÷ 2.25] (or 0.44 × FV). Applying the gross receipts test so rigidly merely reaffirms the concerns McLure and Zodrow raised more than a decade ago when they pointed out: “Since the structures of income and excess profits taxes are inherently different, these differences should be taken into account explicitly in the regulations.” 10

The U.S. Supreme Court’s Response

In contrast to the Third Circuit, the Supreme Court was willing to embrace an algebraic rearrangement of the tax formula. In so doing, it construed the tax as a 51.71% tax on profits above a threshold level, a result it described as “a classic excess profits tax.” Furthermore, the Court expressly adopted a substance-over-form position. Rather than attempting to apply each of the three tests in a mechanical way, the Court looked to the “predominant character” of the tax and whether it was “economically equivalent” to a tax on excess profits irrespective of the wording of the tax under U.K. law. Ultimately, this is a categorical rejection of the IRS’s form-oversubstance approach that it has pursued for many years.

Some Hypothetical Taxes as Examples

Analyzing the Supreme Court’s decision in PPL , it is intriguing to reflect on the type of taxes that would be rejected under the IRS’s approach but might qualify under a substance-over-form approach. For example, imagine a tax that was applied at a rate of 30% to a base equal to two times gross receipts less two times deductible expenses. Applying the tests mechanically, the tax appears to fail the gross receipts test and is thus not a creditable tax. The substance-over-form approach adopted by the Supreme Court, however, would result in the tax’s being recharacterized as a creditable 15% tax on net taxable income.

Another example might be a tax that is imposed on a base equal to end-of-year value less start-of-year value, where end-of year value is defined as starting value plus net value added (essentially a measure of net income). A strict application of the rules suggests that this is a tax on value rather than income, the same argument that the IRS made in PPL . A substance-over-form approach, however, would quickly identify this as an income tax.

As a final example, consider the cash flow tax discussed earlier. McLure and Zodrow describe two types of cash flow taxes, both of which fail a mechanical application of the three tests in the regulations. The first type does not permit a deduction for interest expense, but does permit immediate expensing of capital assets, which violates the net income requirement because it does not allow interest expensing. Yet the immediate write-off of capital assets compensates in present-value terms for the loss of the interest deduction. The second type of cash flow tax requires including loan amounts in income, but permits a corresponding deduction for loan repayments, which fails the realization test. Nonetheless, McLure and Zodrow demonstrate that from an economic standpoint, both of these taxes are equivalent to an excess profits tax. A substance-over-form approach could result in these taxes’ being deemed creditable.

Justice Sotomayor’s Concurring Opinion

Although Justice Sonia Sotomayor concurred with the Court’s opinion, she raised one significant issue: The reformulated tax calculation did not apply to some companies. Specifically, she pointed out that five of the companies had postprivatization periods of less than four years. Using the example of Railtrack, the company that owned the British railway, which had a post-privatization period of only 316 days, she demonstrated that the reformulation in fact results in a tax of 239% of excess profits. This reformulation is shown below:

Windfall Tax = 23% × [(365 × [P ÷ 316] × 9) – FV]

This collapses to 23% × (10.4P – FV)

This can be rewritten as: 239% × (P – 0.1 × FV)

Accordingly, Sotomayor points out that, because both the rate and the base vary from taxpayer to taxpayer, this renders the levy a tax on average income, not excess profits . To highlight her point, she notes that a taxpayer earning $100 million over a four-year period would pay the same tax as a taxpayer that earned $25 million over a one-year period. 11 For example, if the flotation value is $100 million for each of these companies, the windfall tax liability would be $28.75 million for both. 12 Although she does not state this directly, such a result would strongly suggest a clawback of value. That is, if both entities were sold at the same flotation price, both are undervalued by the same amount, and thus the same amount is clawed back (here, $28.75 million) regardless of the years since the time of flotation.

Sotomayor noted that she found the issue persuasive and ignored it only because the government had indicated that outlier companies were not relevant. Commentators have noted that this statement introduces considerable uncertainty about the implications of the final decision. 13 However, it is not clear that the decision would have been different and, in fact, Justice Sotomayor also noted that there is a basis for rejecting outliers as flukes. In fact, while some commentators might suggest that the outlier argument highlights the noncreditability of the tax, 14 the outliers might equally reflect the poor crafting of the U.K. law. This conclusion adds weight to the Supreme Court’s determination to rearrange the formula to get at the true substance of the tax.

The outlier companies in this case actually present a strong indicator of the U.K.’s true intent. Ultimately, the issue hinges on the P/E multiplier of nine. The drafters of the U.K. tax may have erred—the nine should have been converted for those taxpayers with less than four-year post-privatization periods. For example, a taxpayer with a single year should have had a P/E multiple of 2.25 (9 ÷ 4). This would then restore the imputed tax rate to 51.71% of excess profits for all taxpayers , which would strongly suggest an excess profits tax. A taxpayer that had enjoyed only one year of excessive profits should not be subjected to the same degree of clawback as one that had enjoyed four years of excess profitability.

On the other hand, if the tax was in fact designed entirely to capture the difference between the “true” value (the value at which the utility should have been sold) less the actual sale price, the multiplier should remain at nine for all companies—the “true” sale price is deemed to be nine times average profits earned. If this is so, it supports the arguments experts made before the Supreme Court issued its decision that “the Third Circuit appears to have been saying that the alleged equivalence was a function not of the ‘character’ of the tax, but of the particularities of the tax rate involved.” 15

Ultimately, the answer to this question depends on the merits of using the P/E multiplier of nine in valuation, the validity of which is examined in the following section. If such an approach makes sense, then it appears that the U.K. government did in fact intend a value-based tax and the outlier companies therefore are meaningful in understanding the nature of the tax. If instead the formula is viewed as a fiction (as the Supreme Court viewed it), then the U.K. drafters erred by not making the multiplier vary in accordance with the number of post-privatization years, and that error clearly renders the five nonfour-year companies as highly irrelevant outliers.

In other words, Sotomayor’s argument leads to the conclusion that either the U.K. government erred (and incorrectly fixed the P/E ratio at nine) or that the Supreme Court erred in dismissing the argument that the windfall tax is a tax on value rather than excess profit. How outlier companies (which are only outliers in the excess profits tax sense) are characterized, then, has real meaning for understanding the true intent of the tax (excess profits tax or tax on value). Understanding this requires answering the question of how a business should be valued.

How Should a Business Be Valued?

Key to the result of this case is the use of the “value of a disposal in profit-making terms” as a starting point, from which the actual flotation value is subtracted to determine the tax base. The Tax Court heard expert testimony from Stewart C. Myers, a finance professor at MIT’s Sloan School of Management, who pointed out that the entities in question were all publicly traded companies listed on the London Stock Exchange and, if the purpose were to establish the true value as opposed to the flotation value, the market value after the flotation date could have been used. Instead, the statute used the term “value in profit-making terms,” which Myers pointed out is not a standard term in valuation and has no meaning outside the windfall tax setting. Further, Myers noted that the P/E ratio of nine is not used in the context of current or future earnings, which would be the normal use of the term in valuation models.

Given that the model used to ascertain the “true” market value diverges so widely from common valuation approaches, it is difficult to justify this valuation. This divergence from standard valuation practice, along with the ability to reformulate the model in terms of profits over a normal level (excess profits), seems to suggest that the outlier companies are in fact aberrations arising from the statute writers’ failure to correctly identify that the P/E ratio used is really just an arbitrary multiplier, and that it should have been adjusted for those companies with post-privatization periods of less than four years.

Conclusions and Future Implications

Fifteen years ago experts expressed concerns about the form-over-substance mechanical approach the IRS has adopted in applying the regulations for determining the creditability of foreign taxes. The Supreme Court’s decision in PPL seemingly repudiates the IRS’s approach, instead requiring an investigation into the true nature of the tax. In the PPL case, this investigation extended to a reformulation of the tax calculation and a willingness to ignore the implications of outlier companies with anomalous results. The question that remains is whether taxpayers (and tax policymakers in other countries) can now rely on the IRS to reverse its position and adopt a substance-over-form approach. Some commentators have already noted that some government officials are reluctant to see the decision as having a lasting impact. 16

The PPL case highlights the necessity for Treasury to revisit the regulations. Even if the IRS were to evaluate the substance of the tax and not apply the three net gain tests, the results are not entirely clear. Emphasizing the three net gain tests, however, obscures the focus on the substance of the tax. One alternative might be to incorporate greater flexibility into the law, perhaps allowing for both a subjective and objective dimension in determining creditability. This approach is used elsewhere in the tax law, and it is frequently proposed as a solution when there is ambiguity. This approach would recognize that the failure to meet a specific requirement should not automatically disqualify a tax if there are compelling arguments about the substance of that tax. This greater flexibility would address the concerns raised by McLure and Zodrow, 17 who pointed out that the regulations do not encompass excess profits taxes, even though they are specifically mentioned as creditable in Sec. 901. The response of the Supreme Court in the PPL case seemingly confirms that concern.

Regardless of whether Congress or Treasury responds to the PPL case directly, it is clear that the case has significantly affected the landscape when it comes to the creditability of foreign taxes. Unfortunately, all commentators are likely to agree on only one thing, including those who interpret the decision as a step in the right direction and those who see the Supreme Court’s interpretation as being excessively liberal: 18 Whether the IRS will continue to apply a largely legalistic and mechanical approach or will now embrace a shift toward a more substance-over-form approach that is consistent with what the Supreme Court applied remains an unanswered question.


1 PPL Corp., No. 12-43 (U.S. 5/20/13).

2 McLure and Zodrow, “The Economic Case for Foreign Tax Credits for Cash Flow Taxes,” 51 National Tax J. 1 (1998).

3 PPL Corp., 135 T.C. 304 (2010).

4 See, e.g., Fischl, et al., “Taxpayers Score Major Victory on Foreign Tax Creditability in PPL,” 21(12) J. Int’l Tax. 20 (2010).

5 PPL Corp., 665 F.3d 60 (3d Cir. 2011).

6 Biddle, 302 U.S. 573 (1938), which concerned an earlier version of the foreign tax credit under the Revenue Act of 1928.

7 Regs. Sec. 1.901-2(a)(3)(i).

8 McLure and Zodrow, “The Economic Case for Foreign Tax Credits for Cash Flow Taxes,” p. 10.

9 The Third Circuit rounded the result of 365 × 9 ÷ 1,461 to 2.25.

10 McLure and Zodrow, “The Economic Case for Foreign Tax Credits for Cash Flow Taxes,” p. 9.

11 In her opinion, Sotomayor cited the amici curiae brief of Anne Alstott, et al., a group of law professors.

12 23% [(365 × [100 ÷ 1460] × 9) –100] = 28.75 for firm one and 23% [(365 × [25 ÷ 365] × 9) –100] = 28.75 for firm two.

13 For example, in an article published just as this article went to print, Langbein, “PPL, the Foreign Tax Credit and the Gitlitz ‘Finger’ Principle,” 42(10) Tax Management Int’l J. 599–614 (2013), points out that a number of people have criticized the government’s failure to press the argument about outlier companies, including in the Alstott amicus brief. He goes on to note that Justice Sotomayor’s opinion leaves a number of openings for challenging the very same tax in the future using those alternate arguments.

14 Langbein, “PPL, the Foreign Tax Credit and the Gitlitz ‘Finger’ Principle,” raises that concern about the outliers, although he notes that he does not see the issue as the conclusive question.

15 Langbein, “Doing the Math (and the English) in the Windfall Tax Cases,” 42(3) Tax Management Int’l J. 134, 140 (2013).

16 Langbein, “PPL, the Foreign Tax Credit and the Gitlitz ‘Finger’ Principle.”

17 McLure and Zodrow, “The Economic Case for Foreign Tax Credits for Cash Flow Taxes,” p. 10.

18 See Langbein, “PPL, the Foreign Tax Credit and the Gitlitz ‘Finger’ Principle.”



Brett Wilkinson is an associate professor and the Roderick L. Holmes Chair in Accounting in the Department of Accounting and Business Law at Baylor University in Waco, Texas. Katherine Wilkinson is an adjunct professor in the accounting graduate program at Baylor University. For more information about this article, please contact Prof. Wilkinson at










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