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IRS Must Credit Windfall Taxes in UK, Court Says

WASHINGTON (CN) - The "windfall tax" levied against a British utility partly owned by a U.S. company is eligible for a foreign tax credit, the Supreme Court ruled Monday.

After the Labour Party won the 1997 elections, the British government capitalized on public discontent by taxing the excess profits of 32 utilities that had been privatized between 1984 and 1996 by the then-governing Conservative Party.

Profits and share prices for the utilities soared following privatization, as any savings they generated through efficiency were kept as profits rather than passed on to customers.

The windfall tax was a one-time 23 percent tax on the difference between each company's profit-making value and the price at which the government sold it - a price the public considered too low. A company's profit-making value was defined as its average annual profit multiplied by its price-to-earnings ratio.

Pennsylvania-based PPL Corp., which held a 25 percent stake on the UK-based utility South Western Electricity, claimed a credit in its 1997 federal income-tax return under Section 901(b) of the Internal Revenue Code, which grants U.S. corporations a tax credit for "income, war profits, or excess profits taxes" paid to another country.

The Internal Revenue Service denied PPL's claim for a refund, but the Tax Court reversed.

At the commissioner of Internal Revenue's urging, the 3rd Circuit ruled that PPL was not entitled to the foreign tax credit because the windfall tax was not technically a tax on the company's profits, but a tax on the difference between two numbers, one of which was factored in the company's average annual profit over a four-year period.

In a similar case involving the same U.K. tax, the 5th Circuit came to the opposite conclusion, saying courts needed to look beyond form and consider how the tax actually operates.

In its petition to the Supreme Court, PPL argued that the tax is, in substance, a tax on the "excess profits" of the privatized utilities.

The high court took up the case in October, agreeing to clarify whether courts, when deciding if a foreign tax credit applies, should look solely at how the foreign tax is structured or take a more substance-based approach that factors in the tax's practical operation and intended effect.

It unanimously favored PPL on Monday.

"The predominant character of the windfall tax is that of an excess profits tax, a category of income tax in the U.S. sense," Justice Clarence Thomas wrote for the court. "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."

Thomas refused to adopt the commissioner's "rigid construction," which argued that "U. S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt."

"It cannot be squared with the black-letter principle that 'tax law deals in economic realities, not legal abstractions,"" Thomas continued. "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."

Justice Sonia Sotomayor used a concurring opinion to describe a different way of looking at the 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," Sotomayor wrote. "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, and this argument is therefore only pressed by amici, I reserve consideration of this argument for another day and another context and join the court's opinion."

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