The U.S. Supreme Court has agreed to consider whether a domestic taxpayer is entitled to a foreign tax credit based on its payment of a windfall tax to the U.K. government. The Court's decision to grant certiorari in PPL Corp is expected to resolve a split among the circuit courts of appeal.

Facts

Beginning in the mid-1980s, the U.K. privatized several utility companies by selling shares in the public market. Following privatization, costs were reduced, and these utility companies became enormously profitable as a result. The shareholders who initially purchased stock of the utility companies were therefore able to sell the shares at enormous profits. Upon seeing this, the U.K. government effectively concluded that the utility companies were privatized at too low of a price (i.e. the government did not get enough money for the shares). Accordingly, the government decided to impose a windfall profits tax. The windfall tax was a one-time 23 percent tax on the difference between each company's profit-making value and the price for which the U.K. government had sold it. Many U.S. taxpayers had acquired shares in these utility companies. Consequently, the question quickly became whether the windfall profits tax was a creditable tax for foreign tax credit purposes.

Procedural History

The taxpayer involved in PPL filed a refund claim seeking a foreign tax credit for windfall profits tax paid to the U.K. The IRS disallowed the refund and the taxpayer petitioned the Tax Court.

The Tax Court initially held that the taxpayer was entitled to a foreign tax credit on the ground that the tax was on profits making it essentially in the nature of an income tax. However, the IRS appealed, and the Third Circuit Court of Appeals concluded that the windfall profits tax was not a creditable foreign tax and reversed the Tax Court. Significantly, however, the Fifth Circuit Court of Appeals agreed with the Tax Court in a companion case (Entergy Corp.).

Certiorari Granted

As previously mentioned, the Third Circuit and the Fifth Circuit reached opposite conclusions regarding the deductibility of the U.K. windfall profits tax. The Supreme Court opinion will resolve this judicial split between the Third and Fifth Circuits. Hopefully it will also provide some insight for future analysis of foreign tax credit issues. However, the U.K. windfall profits tax is very unique and therefore the opinion will likely be narrow and specific to the nature and characteristics of the U.K. windfall profits tax. With that being said, I would not expect on too much insight beyond what we already have in terms of foreign tax credit analysis as a practical matter.

In today's world of multi-national corporations and globalization, it is not uncommon for a U.S. citizen to live and work abroad in a company's foreign office. Since the U.S. citizen is earning all of his or her income abroad and paying taxes on that income abroad, there should be no tax obligations in the United States, right? Wrong.

The United States operates on a worldwide system of taxation. This means that a U.S. citizen's income is subject to U.S. taxation even if it is earned in another country. The jurisdiction to tax a U.S. citizen's foreign income comes from the fact of U.S. citizenship. As far as the tax law is concerned, U.S. citizenship carries with it certain benefits and protections that follow a U.S. citizen wherever he or she may go in the world. Receipt of these benefits and protections provides the basis for U.S. taxation. Cook v. Tait, 265 U.S. 47 (1924).

Significantly, citizenship as a basis for taxation is not very common. Indeed, only one other country has adopted this approach: the Philippines. Most other countries tax on the basis of residence, not citizenship.

Key Takeaway: If you are a U.S. citizen living abroad, you may still have a U.S. tax obligation. Many countries have lower tax rates than the U.S. In that case, you will likely owe U.S. tax to the extent the U.S. tax rate exceeds the foreign tax rate. Even if the foreign tax rate equals or exceeds the U.S. tax rate, you may still owe U.S. tax. In any event, taxpayers are always well-advised to file a return - even if they think no tax is owed - because the statute of limitations does not begin to run unless and until a tax return is filed.

I.R.C. § 904(a) provides that "[t]he total amount of [foreign tax credit] . . . shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer's taxable income from sources without the United States bears to his entire taxable income for the same taxable year."

Translation: the foreign tax credit allowed is not necessarily equal to foreign taxes paid.

The foreign tax credit limitation is computed using the following formula:

U.S. tentative tax liability x [foreign source taxable income/worldwide taxable income]

The effect of this formula is to limit the foreign tax credit to U.S. taxation of foreign source income. In other words, a foreign tax credit cannot exceed the maximum U.S. tax rate. As a result, the foreign tax credit may be limited when foreign taxes are paid to a country with higher tax rates than the United States.

Example. A taxpayer has $500 U.S. source income and $500 French source income. Assume that this taxpayer is subject to a tax rate of 35% in the U.S. and a tax rate of 40% in France. Thus, this taxpayer will have paid $200 of French tax ($500 French source income * 40%).

The United States has a worldwide system of taxation. This means that U.S. taxpayers are subject to U.S. taxation with respect to both domestic and foreign source income. In the above example, this means that the taxpayer's tentative U.S. tax liability is equal to $350 (35% * $1,000 worldwide income).

The $350 tentative U.S. tax liability is then multiplied by the ratio of foreign source taxable income to worldwide taxable income. The effect of this calculation is to limit the allowable foreign tax credit to $175 - $350 x [$500 foreign source income/$1,000 worldwide taxable income]. Thus, the taxpayer's foreign tax credit would be limited to $175 despite payment of $200 in foreign tax.

In some cases, foreign source income may be recharacterized as domestic source income and vice versa. In addition, separate calculations may be required for different types of income. For these reasons, it is important for foreign taxpayers to seek advice from a tax professional who can accurately calculate domestic and foreign source income.

Do you have foreign source income? I can help you maximize your foreign tax credit and minimize your overall tax liability. Contact me today for a free consultation.