The IRS claimed that the Tax Court’s ruling regarding the application of Section 901, 26 C.F.R. § 1.901-2(a) for the treatment of the Windfall Tax for Entergy, T.C. and in the PPL Corp. case were erroneous because taxes imposed on both companies were not based on excess profits and did not meet the three-part predominant character test. According to the IRS, the profit-making value was a demonstration of the tax reaching unrealized value and did not constitute as a tax on excess profits.
Like Entergy, the IRS agreed that the Tax Court properly applied 26 C.F.R. § 1.901-2(a) to the issues at hand. Under 26 C.F.R. § 1.901-2(a), “a foreign levy is an income tax if and only if…the predominant character of that tax is an income tax in the U.S. sense if it is likely to reach net gain in the normal circumstances in which it applies”. To apply this statute, the foreign taxes paid by an entity must meet all three of the requirements outlined in the three-part predominant character test.
Application of the components of the three-part test state that the foreign tax must satisfy the realization, gross receipts, and net income requirements. This is where the IRS disagreed with the Tax Court. The IRS claimed that the terms and text of the Windfall Tax clearly stated that the tax was based on identifiable differences in statutory values or a taxpayer’s “profit- making value”. Additionally, the IRS argued that the Tax Court was obligated to reexamine the content of the text of the Windfall Tax without consideration of the historical and mathematical sources. The IRS further stated that the Tax Court had to rely exclusively on the wording/text in the Windfall Tax as it related to profit making value to determine the tax’s predominant character. According to the IRS’ view of the tax, the Parliament’s use of firms’ average profits over a specified period indicated that it was not intended to affect gross receipts.
Entergy’s argument was based on two factors, the requirements for the three-part dominant character test and the purpose and calculation of the Windfall Tax. The Windfall Tax was created after the UK realized that is set price controls on the 32 utility companies that it privatized, but failed to set a cap on profits, which resulted in the privatized companies incurring smaller than expected costs; unprecedented profits, share prices, and executive compensation; and public backlash.
In response to the public backlash, the Parliament implemented the Windfall Tax as a levy on the excess profits generated by the privatized utilities companies. The taxpayer’s justification for revising the tax returns for the 1997 and 1998 to reflect the foreign tax focused on the Parliament’s use of gross receipt taxes and profit taxes to recoup taxes of previously-earned profits. The calculation used by the Parliament imposed a one-time 23 percent assessment on Entergy’s and the other companies’ difference between their profit-making values and flotation values using calculations that used imputations based on price-earnings ratios and their respective privatization prices.
After the IRS rejected Entergy’s revised tax returns, the company appealed the decision with claims “that the Windfall Tax could be mathematically re-expressed as a pure tax on profits”. According to Entergy, the amendment of the prior years’ returns and the claim for a $234 million credit was justified because the Windfall Tax met the three-part predominant character test and the tax was imposed on income that the company had already realized during the four-year period used to calculate the tax. Additionally, the tax was imposed on Entergy’s gross receipts during the four-year period; hence the use of the profit-making value that considered the gross receipts to determine profits. The tax also met the third requirement because it specifically targeted the company’s net income, thus profits.
The Court agreed with Entergy’s interpretation of the Windfall Tax and affirmed the prior court’s ruling while providing thorough explanations for its justification and highlighting areas where the IRS erred. The IRS’ primary claim against the use of the Windfall Tax was the wording that referenced “profit-making value” where it claimed that this wording alone was a clear indication that the tax was based on unrealized values. In response to this claim, the Court stated that the use of the text “profit-making value” was irrelevant because when the tax was developed, the taxing authority knew which specific companies would be taxed; was knowledgeable of and used the specific companies’ after-tax profits as the tax base; and had a preset amount of revenue that it intended to raise. According to the Court, these facts as well as the design of the Windfall Tax calculation formula constituted as an excess tax on Entergy and the other select companies’ excess profits.
Another argument raised by the IRS was the base used by the Parliament to calculate the Windfall Tax. The Tax Court refuted the IRS’ argument on the grounds that case law, specifically 26 C.F.R. § 1.901-2, does not provide specific determinants for the label and form of a foreign tax as gross income or net income. Instead, the Court stated that the primary focus should be on determining if the government of the foreign country intended to use the tax to reach some type of net gain.
The IRS also argued that the Windfall Tax failed to meet the foreign tax requirement because the Parliament calculated the tax using the companies’ average profits over an initial period; therefore, it was not directly based on gross receipts. However, the Court disagreed stating that the character of the tax was more relevant because the claw back component of the tax required it to base the companies’ tax liabilities on “gross receipts less expenses from those receipts or net income”. Additionally, like taxes on profits on firms in the United States, changes in the Windfall Tax amounts were directly related to the profits above a fixed floor and the text of the tax clearly states that it was intended to “obscure the history and actual effect of the tax”.
In the end, the Appellate Court confirmed the Tax Court’s ruling on the true intent of the Windfall Tax on two grounds. The first was that it satisfied the realization and net income requirement because it considered realized revenues generated from the utility company’s ordinary operations prior to designing and implementing the tax and estimated that the taxes would increase with the companies’ profits. Secondly, the design of the tax only allowed it to affect profits that the utility companies realized during the relevant period and calculated profits in the ordinary sense, thus satisfying the net income requirement.