The Supreme Court this morning unanimously ruled in favor of PPL in its case involving the creditability of the U.K. Windfall tax.  See our prior coverage here.  The opinion was authored by Justice Thomas, with Justice Sotomayor adding a separate concurring opinion.

The Court’s opinion is fairly succinct.  Viewing the government’s position as more formalistic, the Court stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.”  The Court stated that the regulatory test looks to “the normal manner is which a tax applies,” and “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.”

Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable.  By contrast, the Court found that the government’s attempt to characterize the tax as being imposed on the difference between two values was unrealistic, noting that the U.K. statute’s “conception of ‘profit-making value’ as a backward-looking analysis of historic profits is not a recognized valuation method,” but instead “is a fictitious value.”  The Court agreed with PPL’s argument that the equivalency of the tax with a more typical excess profits tax could be demonstrated through an algebraic reformulation of the formula for computing the tax.  The Court addressed this point in some detail, putting this opinion near or at the top of the rankings in the category of most algebraic formulas found in a single Supreme Court opinion.  Declaring that it must look at “economic realities, not legal abstractions,” the Court concluded that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.”

Justice Sotomayor’s separate concurring opinion focused on an issue that featured prominently in the oral argument (see our report here) — namely, how the analysis is affected by the way the tax applied to a few “outlier” taxpayers who did not operate for the full four-year period governed by the tax.  Echoing the position taken in an amicus brief filed by a group of law school professors, Justice Sotomayor stated that the treatment of these outliers indicated that “the windfall tax is really a tax on average profits” and ought to be viewed as a tax on a company’s value, not net income.  Justice Sotomayor acknowledged, however, that her position “cannot get off the ground” unless the Tax Court was wrong in stating in Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), that “a tax only needs to be an income tax for ‘a substantial number of taxpayers’ and does not have to ‘satisfy the predominant character test in its application to all taxpayers.’”  Since the government indicated at oral argument that it did not disagree with the Tax Court on that point, Justice Sotomayor concluded that she should not base her analysis of the case on her “outlier” argument and instead would join the Court’s opinion.  Interestingly, Justice Kagan did not join the concurrence even though she was the Justice who appeared at the oral argument to advocate most strongly for the “outlier argument” made in the amicus brief.

For its part, the majority briefly noted this argument in a footnote at the end of its opinion, and stated that it would “express no view on its merits” since the government had not preserved the argument.  Notwithstanding that disclaimer, the body of the Court’s opinion provides ammunition for persons who might wish to oppose Justice Sotomayor’s position in future cases.  The Court stated that the predominant character test means that “a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently.”  Another item in the opinion that could find its way into briefs in future foreign tax credit cases is the Court’s observation that the 1983 regulation at issue ”codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938).”  In its court of appeals briefing in PPL, the government had denigrated the relevance of pre-regulation case law, stating that the regulations merely “incorporate certain general standards from those cases,” and arguing that PPL “cannot rely on pre-regulation case law—to the exclusion of the specific regulatory test—to make its case.”  The Court’s opinion will lend support to litigants who want to rely on pre-regulation case law in future foreign tax credit cases.

The Court’s opinion in PPL effectively resolves the Entergy case as well.  As we have reported, the government filed a protective petition for certiorari in Entergy, but it has never suggested that PPL and Entergy should be decided differently.  Thus, in the near future, probably next Tuesday, the Court can be expected to issue an order denying that certiorari petition and thereby finalizing Entergy’s victory in the Fifth Circuit.

As we previously noted, the taxpayer faces an uphill battle because the Court rarely hears technical tax cases over the government’s opposition in the absence of a circuit conflict.  The Court is expected to act on the petition on May 28.

Both cases involved the character of the golfers’ endorsement income.  Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade.  The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%).  Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights.  So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement.  The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services.  But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement.  But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services.  And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen.  As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income.  But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s.  The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.”  Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty.  Perhaps the IRS will appeal that legal issue.  Will Garcia appeal?  The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen.  On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal.  Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

Garcia – Tax Court Opinion

Five former IRS Commissioners filed an amicus brief in support of the Government’s appeal of the district court decision invalidating the IRS’s registration regime for paid tax return preparers.  The former Commissioners “take no position regarding whether the manner in which the Treasury has chosen to regulate tax return preparers is advisable, but they strongly disagree with the District Court’s view that Congress has not empowered Treasury to do so.”  Under 31 U.S.C. § 330, the Treasury Department is authorized to “regulate the practice of representatives of persons before the Department of Treasury.”  The district court held that, although the statute did not define “the practice of representatives,” the surrounding statutory text made clear that Congress used “practice” to refer to “advising and assisting persons in presenting their case,” not simply preparing returns.  In their amicus brief, the former Commissioners argue that filing a tax return does, in fact, constitute presenting a case.  The amicus brief explains that an increasingly wide variety of government assistance programs are administered through the federal income tax system, including a number of refundable tax credits (the earned income credit, health insurance cost credit, etc.).  Accordingly, the tax return preparer is not simply calculating tax liability; he or she also is often representing the taxpayer in pursuing claims for federal assistance.  Because disbursements of benefits under these government assistance programs is administered largely through self-reporting on a tax return, it is essential, the former Commissioners argue, that paid tax return preparers be regulated so that taxpayers can identify the credits and benefits to which they are entitled and so that both the government and taxpayers are protected against fraud.

The National Consumer Law Center and National Community Tax Coalition also filed a joint amicus brief arguing for reversal of the district court’s decision.  That brief documents “rampant” fraud and incompetence in the paid preparation industry, especially on the part of fringe return preparers, such as payday loan stores.

Loving – Former Commissioners’ Amicus Brief

Loving- NCLC/NCTC Amicus Brief

In their reply brief, the taxpayers argue that the general rule of section 163(a) (“There shall be allowed as a deduction all interest paid within the taxable year on indebtedness.”) must be read as referring to the taxpayer’s indebtedness.  This “clearly implied” meaning, they argue, should inform the interpretation of the mortgage interest deduction provisions.  The taxpayers also seek support for their interpretation in references in the legislative history to the indebtedness on the qualified residence as being “the taxpayer’s debt.”  With respect to the Government’s marriage penalty argument, the taxpayers note that the Code often treats married couples as a single taxpayer, and married couples enjoy many benefits from that treatment, benefits that are not enjoyed by domestic partners.  The reply brief concludes with the following:  “Once Congress made the decision to treat spouses as a  single taxpayer, the resulting benefits and burdens must be respected equally.  In this case, Taxpayers should not be assigned the burden (or penalty) that results from the Tax Court’s convoluted reading of section 163(h)(3) which treats Taxpayers as a married couple, when they receive none of the marriage benefits.”

Sophy – Government’s Brief

Sophy – Taxpayers’ Reply Brief

With this extension, however, the Court likely will not decide whether to grant certiorari until early October, after the summer recess.  If Quality Stores were to file its response to the cert petition early, however, without taking its full 30 days to respond, then the petition could still be ready for a ruling by the Court before the summer recess.  In either event, if the Court were to grant certiorari, the case would probably be argued in late 2013, with a decision on the merits expected by June 2014.

In its opening brief, the Government argues that the tax return preparer regulations are a reasonable interpretation of an ambiguous statutory grant of authority to regulate the “practice of representatives before the Department of Treasury.”  The district court had held that the Treasury Department was not entitled to any Chevron deference because the statute, 31 U.S.C. 330(a)(1) unambiguously did not authorize the regulation of individuals whose only role is the preparation of the return.  The Government argues that “neither the actual language nor the overall context of 31 U.S.C. 330(a) unambiguously forecloses the Secretary’s interpretation that the term ‘ practice of representatives before the Department of the Treasury’ includes the practice of tax-return preparers.”  The Government pointed to the absence of a definition — either in the Code or in ordinary meaning — of “practice” that would exclude mere return preparation.  The Government also seizes on language in 31 U.S.C. 330(a)(2) authorizing the Secretary of the Treasury to require that representatives who practice before it demonstrate “necessary qualifications to enable the representative to provide to persons valuable service.”  The Government reasons that, because tax return preparers provide a ”valuable service,” they should be deemed to ”practice” before the Treasury Department.   Acknowledging that the statute authorizes the Treasury Department to require a representative to demonstrate “competency to advise and assist persons in presenting their cases,” the Government contends that Congress did not intend by that language to limit the Treasury Department’s authority to regulate tax-return preparers whose representation ends with preparing the tax return.

Loving – Government’s Opening Brief

Loving- Government’s Motion to Expedite Appeal

In Peco Foods, the Commissioner used that rule (along with the allocation rules under section 1060) to prevent the taxpayer from subdividing broader classes of purchased assets (to which the purchase agreement had expressly allocated a portion of the purchase price) into discernible subcomponents for depreciation purposes.  The taxpayer is a poultry processor that purchased the assets at two poultry processing plants in the mid- to late-1990s.  In each of the purchase transactions, Peco and the seller agreed to allocate the purchase price among listed assets “for all purposes (including financial accounting and tax purposes).”  The first agreement allocated purchase price among 26 listed assets; the second allocated purchase price among three broad classes of assets.

Prompted by the Tax Court’s decision in Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Peco commissioned a cost segregation study that subdivided the listed assets into subcomponents.  Some of these subcomponents fell into asset classes that are subject to accelerated depreciation methods.  For instance, Peco subdivided the class of assets listed as “Real Property: Improvements” on the original allocation schedule into subcomponents that were tangible personal property subject to a 7- or 15-year depreciation period under section 1245.  If they were classified as structural components of nonresidential real property, the assets would have been subject to a 39-year depreciation period under section 1250.

With the segregation study in hand, Peco applied to change its accounting method for those subcomponents with its 1998 return and claimed higher depreciation deductions on subsequent returns.  The IRS disallowed these deductions and issued a notice of deficiency; the taxpayer filed a petition in Tax Court.

In a Tax Court Memorandum opinion by Judge Laro, T.C. Memo 2012-18, the Tax Court upheld the Commissioner’s deficiencies.  The Tax Court’s decision was based on both the Danielson rule and section 1060(a), the latter of which provides that if the parties in an applicable asset acquisition “agree in writing as to the allocation of any consideration,” the agreement “shall be binding on both the transferee and transferor unless the Secretary determines that such allocation . . . is not appropriate.”  The taxpayer argued that section 1060 serves only to allocate purchase price among assets under the residual method of section 338(b)(5) and that section 1060 does not bar further subdivision of the allocation for purposes of determining useful lives for depreciation.  The Tax Court held that the directive in section 1060 that an allocation by the parties “shall be binding” trumps the application of the residual method of section 338(b)(5).

The Tax Court also rejected the taxpayer’s argument that Danielson was inapposite.  The taxpayer had relied on United States v. Fort, 638 F.3d 1334 (11th Cir. 2011), in which the Eleventh Circuit held that “the Danielson rule applies if a taxpayer ‘challenge[s] the form of a transaction.’”  (citation omitted)  Since the taxpayer in Fort had challenged the specific tax consequences of the form of the transaction but not the form itself, the Eleventh Circuit found that Fort fell outside the scope of the Danielson rule.  The Tax Court held that while the taxpayer in Fort had not challenged the form of the transaction, the taxpayer in Peco—by “seeking to reallocate the purchase price among assets not listed in the original allocation schedules”—sought to challenge the form of the transaction.  Therefore, reasoned the Tax Court, because there was no ambiguity to the allocations in the purchase agreements under the applicable contract laws of the states in which the agreements were entered, Danielson applies to prevent the taxpayer from subdividing the listed into distinct components for depreciation purposes.

On appeal, the taxpayer contests the Tax Court’s holdings with respect to both section 1060 and Danielson.  In its brief, the taxpayer argues that whether an asset is tangible personal property or a structural component of a building is a matter of facts and circumstances and that the words used to describe the asset “are of no utility in connection with its categorization as a structural component.”  The taxpayer also argues that classifying assets for depreciation purposes is not a challenge to the form of the transaction (unlike, for example, treating the transaction as a merger or lease rather than an asset acquisition, which would have been a challenge to form) and therefore, under the holding in Fort, the Danielson rule does not apply.

In his opposition brief, the Commissioner echoes the Tax Court’s holding that the taxpayer’s subdivision of listed assets for depreciation purposes is an attempt to “restructure the form of the transaction” and therefore falls within the purview of the Danielson rule (and is not excluded by the rule articulated in Fort).  The Commissioner then goes a step further, arguing that the taxpayer was not merely “changing the classification of assets” but also “added assets.”  Moreover, the Commissioner insists that what the taxpayer did with respect to depreciation “goes considerably deeper than merely a change to the classification for depreciation purposes.”

Peco Foods – Tax Court Memorandum Opinion

Peco Foods – Taxpayer’s 11th Circuit Brief

Peco Foods – Commissioner’s 11th Circuit Opposition Brief