By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
It is a common perception among those unfamiliar with actual tax practice that, to be a good tax lawyer, one must be a good mathematician. The arguments made and the circuit court decisions in two cases dealing with the creditability of the U.K. Windfall Tax demonstrate that that perception is not always true.
The U.K. Windfall Tax was a tax enacted by a Labour government to deal with perceived problems created by the prior Conservative government's privatization of 32 formerly-government-owned U.K. companies, chiefly regulated public utilities. The problems boiled down to two: (1) the companies were sold for too little; and (2) they made "excessive" profits in the years immediately following privatization.
Three of the companies were U.S.-owned and claimed a foreign tax credit for the U.K. Windfall Tax paid. In two of the cases,1 the IRS denied the credits, asserting that the Windfall Tax was not an income tax. In both cases, the Tax Court disagreed with the IRS, agreeing with the taxpayers' position that the Windfall Tax was a creditable income tax. One of the two cases was appealed to the Third Circuit, which reversed and held for the government. The other went to the Fifth Circuit which affirmed, holding for the taxpayer. Petitions for certiorari were filed in both cases and the Supreme Court granted certiorari on October 29, 2012.2
The litigants' arguments included the assertion that "basic algebra" proved that the Windfall Tax was an income tax, not a non-creditable value tax. The Third Circuit's decision, devoted largely to the same basic algebra, came to the opposite conclusion, i.e., that the algebra proved the Windfall Tax not to be levied on a permissible income base.
With the petitions for certiorari granted to resolve the split in the circuits, I would like to offer some unsolicited advice to the litigants: avoid spending too much ink and time on the "basic algebra" of the Windfall Tax that has resulted in two diametrically opposed conclusions.
Allow me to call the arguments that algebra either proves or disproves the creditability of the U.K. Windfall Tax the "math argument." The math argument starts with the U.K. Windfall Tax's statutory taxing formula:23% ((Average profit × 9) - Flotation value) = Tax where, in accordance with the statute, "Average profit" is determined by taking the positive profit, if any, from each of the first four (or fewer) years following flotation but before 1997 and dividing by the number of years in that period. This, then, can be restated as:(.23 × 9 × Average profit) - (.23 × Flotation value) = Tax or 207% × Average profit - (.23 × Flotation value) = Tax.
At this point my math ability gets rather stretched but, if I understand them correctly, those that believe the math argument helps to demonstrate creditability believe that the above formula can be restated as:(51.75% Year 1 profit) + (51.75% Year 2 profit) + (51.75% Year 3 profit) + (51.75% Year 4 profit) - (.23 × Flotation value) = Tax.
Thirteen years ago when I first was presented with this argument, I sought to check this last restatement with someone far more adept at algebra (and closer to having recently learned it) than myself: my then-teenaged older daughter. She informed me (and confirmed with her middle school algebra teacher who had an advanced degree in math) that this last restatement might not be entirely technically correct in every case, though it could be correct in many cases. Instead, in the technically precise restatement, there needed to be inserted a large sigma symbol and some little numbers3 to properly reflect the concept of a four- (or fewer-) year average (which was the case for several of the Windfall Tax taxpayers).
To translate the formula with the hard-to-print symbol into English, the bottom line was that a more technically correct restatement for any taxpayer for whom the averaging period for determining average profits was less than four years would not produce the four-year restated formula above. For at least one taxpayer, for example, the averaging period was something like one and one-half years. Again straining my math ability, I believe this means that the restated formula, in that individual case, would be something like:(138% Year 1 profit) + (138% Year 2 profit) - (.23 Flotation value) = Tax.
For a taxpayer with a full-two-year averaging period, the restated formula, again in that individual case, would be:(103% Year 1 profit) + (103% Year 2 profit) - (.23 Flotation value) = Tax.
Because the averaging period can be (and was, in at least one case) less than four years, it seems incorrect to restate the tax as 51.75% of the sum of four years of actual profit for every case. The percentage of actual annual profit that is taxed could vary depending on the number of years in the averaging period. What this demonstrates is that the Windfall Tax might be viewed, if viewed solely through the lens of the math argument, as a tax on a single year's profit, computed using an average. It is arguably not a tax on four years' profits, aggregated, and assessed once, at least not always as the math argument might suggest.
This is essentially the Third Circuit's thinking-that it is misleading or incorrect to restate a one-time tax on an average amount as a continuing tax on four annual amounts. In other words, the court used basic algebra to show that the litigants' restatement of the U.K. statutory taxing formula (using somewhat different shorthand and calculations than above) should, in fact, be stated as: Windfall Tax = 23% × (2.25 x profit) or Windfall Tax = 23% × [(2.25 x gross receipts) - (2.25 x expenses)].
The Third Circuit refused to allow the 2.25 to be divided into four separate parts to reflect the four years in most taxpayers' computation of the average profit.4 While its explanation for this refusal is not entirely clear, it appears that the rationale stated above regarding the four-year period and averaging may have been the underlying motivation. The court then took this result of its understanding of the basic algebra and concluded that the Windfall Tax formula violated the gross receipts requirement as well as the realization requirement of the regulations because it purported to tax an amount two and a quarter times greater than actual gross receipts. Because the formula could be restated to show that the gross receipts and realization tests might, based solely on algebra, not be met, the court held that the tax was imposed on a tax base other than income. Theoretically not being imposed on an income base, the Windfall Tax was held not creditable.
Even if, based on the analysis above, the litigants' math argument is flawed, the Third Circuit's decision is even more flawed. By focusing almost exclusively on the math argument and the court's view of what it theoretically "proves," the Court misses the fact that, in actual practice, the Windfall Tax was imposed on an amount greater than a taxpayer's total profit during the four-year period in only one case (and that a non-U.S.-owned case) out of the 32 U.K. companies subject to the one-time Windfall Tax. And in determining the "predominant character" of a foreign tax by examining its operation, its operation- where the number of taxpayers and the number of periods it is assessed are both relatively small-can be determined by looking at the actual operation on the actual taxpayers. There is no need for a court to base its determination on the theoretical application of the taxing formula. It can (as is the case with the Windfall Tax and was the case previously with the Ontario Mining Tax) take evidence regarding the entire actual application of the foreign tax. If it applies in the vast majority of cases to a tax base that consists only of net income, that tax should be considered an income tax. The U.K. Windfall Tax is such a tax.
The Third Circuit, it appears, decided the Windfall Tax case based solely on a rebuttal of the math argument and not on how the tax operated in practice. It may be that the precision of mathematics persuaded the court that it had a precise way to decide the case, without looking beyond mathematics. What it did not do, unlike the Fifth Circuit, was to look at the actual application of the tax to actual taxpayers. The tax lawyers for the litigants in these cases, and the tax lawyers for the litigants in the third case yet to be docketed, should take a lesson from the Third Circuit's decision and avoid getting tangled up in the algebra. A misunderstanding of how to express an algebraic statement that properly reflects a foreign tax such as the Windfall Tax, and a misunderstanding of what such a statement says about the actual operation of a tax, can lead both tax lawyers and courts into trouble.
This commentary also will appear in the December 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes - General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.
1 The third case is still pending.
2 PPL Corp. v. Comr., 665 F.3d 60 (3d Cir. 2011), cert. granted, No. 12-43 (U.S. 10/29/12). See also "Supreme Court to Resolve Circuit Split on U.K. Tax's Qualification as Foreign Tax," 209 Daily Tax Report K-1 (10/30/12).
3 The reader will forgive me for not annoying my publisher by trying to describe this with the correct symbols.
4 Actually, the Third Circuit focused on and objected to the idea that the litigants' restated formula restated the tax rate as 51.75% (when the actual rate was 23%) times each of four year's profits. It is equally valid to say that the litigants' restatement simply took what translated to 207% of an average profit computed over four years and divided the profit into four pieces. That, however, has the potential infirmities discussed above.