Court's reasoning


In PPL Corp v Commissioner(1) the Tax Court recently held that the UK 'windfall tax'(2) is creditable for US tax purposes. The tax was imposed on utility companies that have been privatised. In general, the UK government and the public seem to feel that the utilities were sold for too little, and the one-time windfall tax appears to be a means of recouping some of the value forgone on the sale. The tax was imposed at a rate of 23% on the excess, if any, of "the value in profit-making terms of the disposal made on the occasion of the company's flotation" over the "value which for privatisation purposes was put on that disposal". The former value was then defined as nine times a company's average annual profit (as calculated over the four financial years after sale, unless the company had fewer than four such years before April 1997). The court's decision conflicts with an Internal Revenue Service (IRS) 'field service advice' which found that the tax was not creditable.(3)

Court's reasoning

The preliminary question for decision was whether the windfall tax's creditability should be determined only by reference to its text, which defined the tax base as the difference between two values, or whether the intent and effect of the tax were also relevant. The IRS argued for the former position, while the taxpayer argued for the latter and contended that the tax was imposed on excess profits. The court ultimately agreed with the taxpayer.

The court noted that the Treasury Regulations examine whether a tax "is likely to reach net gain in the normal circumstances in which it applies".(4) This led the court to state that:

"By implicating the circumstances of application in the determination of the predominant character of a foreign tax, the drafters of the 1983 regulations clearly signaled their intent that factors extrinsic to the text of the foreign tax statute play a role… the inquiry being whether the tax is designed to and does, in fact, reach net gain… regardless of the form of the foreign tax…"(5)

The court determined that pre-1983-regulations cases, which are cited in the regulations' preamble as being the basis for the regulatory test, went beyond the text of foreign law and examined the purpose and effect of the foreign law.(6) Post-1983 cases applied similar reasoning.(7)

Those cases examined whether denial of certain deductions, and allowance of alternative amounts to substitute for such deductions, caused foreign taxes to fail the net income portion of the creditability test. However, the court concluded that the reasoning in those cases is not limited to that narrow fact pattern: "[T]he overall issue for decision in those cases, as in this case, was whether the foreign tax was designed to, and did, in fact, reach net gain."

The court held that the purpose and effect (not just the literal words) of a foreign tax are relevant to the creditability analysis. Thus, it reasoned, a tax that by its text applies to gross income (as in Bank of America) can qualify as a net income tax, and a tax that literally applies to value (such as the windfall tax) can be analysed as a tax imposed on profits.(8) The court rejected the IRS's argument that the form of a tax is determinative.


The court concluded that the windfall tax was intended to, and did in fact (for most taxpayers), reach profits. The tax was justified in the United Kingdom by two rationales: (i) the companies were sold too cheaply, and (ii) their after-sale profits were too high. The court found these rationales to be equivalent and inter-linked, which supported the idea that the tax was intended to reach profits. The court also took into account that the tax did not exceed profits for any taxpayer. The PPL opinion holds that the windfall tax qualifies as a creditable tax on excess profits because "the design and incidence of the tax convinces us that its predominant character is that of a tax on excess profits".

The same judge reached the same conclusion regarding creditability of the UK windfall tax in another opinion issued on the same day.(9) That case has an abbreviated, one-page opinion, and cites PPL.(10)


One could agree with the court's decision on the grounds that the general purpose of the foreign tax credit is served by granting a credit if the foreign tax in practice reaches net income. In addition, the regulations do indeed examine whether a tax is "likely to reach net gain in the normal circumstances in which it applies".(11) However, the regulations also include specific tests to effectuate that concept. Under the regulations:

"A foreign tax is likely to reach net gain in the normal circumstances in which it applies if and only if the tax, judged on the basis of its predominant character, satisfies each of the realization, gross receipts, and net income tests set forth [in the regulations]."(12)

Essentially (and without a detailed discussion), the PPL court found that the realization, gross receipts, and net income tests were met because the windfall tax in effect is, and was intended to be, imposed on profits.

There are several possible counterarguments to the court's reasoning, including the following. First, the impetus for the windfall tax appears to be that the companies were sold for too little – that is, there is a focus on value rather than income. The court said that this undervaluation rationale and the idea of too many post-sale profits were interchangeable. But one could argue that the use of profits in the tax base calculation is simply a means of computing what the sale value should have been. Second, the cases which the court cited were limited to one fact pattern and focused on the net income portion of the creditability test.

The IRS's options now include appealing the case and changing the regulations to provide that the text and form of a foreign statute – not its intent and effect – are controlling. Alternatively, the IRS could amend the regulations to provide that examination of intent and effect is limited to the net income prong of the three-prong "predominant character... of an income tax" test. Such a limitation would be consistent with the cases relied on by the PPL court, all of which concerned the net income prong.

For further information on this topic please contact Rebecca Rosenberg at Caplin & Drysdale by telephone (+1 202 862 5000), fax (+1 202 429 3301) or email (rir@capdale.com).


(1) 135 TC No 15 (2010).

(2) Part 1 of Chapter 58, Finance (No 2) Act 1997.

(3) See FSA 200112011.

(4) Treas Reg Section 1.901-2(a)(3)(i).

(5) PPL, text between Notes 26 and 27.

(6) See Inland Steel Co v United States, 230 Ct. Cl. 314, 677 F.2d 72 (1982), Bank of America Nat'l Trust v United States, 459 F2d 513 (Ct Cl 1972), Bank of America Nat'l Trust v Commissioner, 61 T.C. 752 (1974), aff'd w/out pub'd op 538 F2d 334 (9th Cir 1976).

(7) See Exxon Corp v Commissioner, 113 TC 338 (1999), Texasgulf v Commissioner, 107 TC 51 (1996), aff'd 172 F3d 209 (2nd Cir 1999). Taxpayers prevailed in many of these cases (with the exception of Inland Steel).

(8) PPL at text accompanying Note 31.

(9) See Entergy Corp v Commissioner, TC Memo 2010-197.

(10) Note that Entergy's citation is mis-stated in PPL, where it is given as TC Memo 2010-198.

(11) Treas Reg Section 1.901-2(a)(3)(i).

(12) Treas Reg Section 1.901-2(b)(1) (emphasis added).

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