The legal dispute reflects the fact that economically identical taxes may be creditable or not, depending on how they are formally described. For example, if you had a $5 perpetuity and the pre-tax interest rate is 5%, so it is worth $100, a 40% "income tax" is hard to tell apart from a 2% "property tax," since either one will cost you $2 per year. Yet only foreign "income, war profits, and excess profits taxes" qualify for the foreign tax credit.
The IRS has raised a few eyebrows, along with a legal challenge that generated a circuit split and Supreme Court review, by taking an apparently formalistic stance here, and saying that the U.K. tax is not creditable because it was not called or expressly structured as an income tax. More often, the IRS wants to look at economic substance, while taxpayers rest their cases on self-selected form that supports favorable tax results.
But here, saying that "substance" should control runs into the problem that the underlying law on its face rests on arbitrary and formalistic distinctions. Should any tax that can be shown to be equivalent to an income tax be creditable, even though it's clear that some such taxes are not meant to be creditable? If so, then how exactly is one supposed to draw the fantastical line between taxes that win due to income tax equivalence and those that lose despite it (and thus that are also equivalent to the ones that win)?
In today's Tax Notes, Alan Viard has a very nice piece exploring PPL's conundra. Rather than argue that the case should come out one way or the other, he uses it as a vehicle to expose the fundamental problems with foreign tax creditability and the related illogic and arbitrariness of efforts to draw lines between taxes that are creditable and those that are not. In addition to agreeing with his analysis, I'll admit to having been personally gladdened by his references to some of my recent work on foreign tax credits (to be further developed in my forthcoming book on international tax policy). A few samples of the article's discussion include the following:
"Reiterating a point made a half century ago by Peggy Musgrave, Daniel N. Shaviro of the New York University School of Law recently emphasized that from the standpoint of American well-being, U.S. taxpayers’ foreign income tax payments are no different than their other foreign tax payments, nontax foreign business costs, and reductions in foreign income. The credit reduces American well-being by artificially and inefficiently diluting U.S. taxpayers’ incentives to minimize foreign income taxes, because those taxes can be offset by the credit. The credit prompts American companies to operate in high-tax countries, to be less zealous in challenging foreign tax assessments, and to enter transactions that reallocate other parties’ foreign income tax liabilities to them in exchange for other benefits. Statutory and regulatory restrictions on the credit cannot satisfactorily combat those incentives....
"Despite its unusual generosity, the FTC has enjoyed almost unanimous support" [For example, to bring out the lack of coherent - or any - analysis more bluntly than Viard does, it's not classified as a tax expenditure because it's not classified as a tax expenditure. That is to say, it has not been defined as a tax expenditure because it has been defined as not a tax expenditure.] ....
"Empirical evidence recently presented by Kimberly Clausing and Shaviro confirms that a country’s provision of an FTC prompts its investors to direct their overseas investments toward high-tax countries. Clausing and Shaviro found that OECD countries with credits placed a larger share of their foreign direct investment in high-tax countries (statutory corporate tax rate above 30 percent) and a smaller share in low-tax countries (statutory rate below 15 percent) than the OECD countries that exempt overseas income or have a hybrid credit/exemption system. The difference persisted in a statistical analysis that controlled for countries’ GDP levels, geographical distance, and other relevant variables.