Briefing Completed in PPL

[Note:  Miller & Chevalier represents amicus curiae American Electric Power Co. in this case.]

The PPL case is now fully briefed in the Third Circuit and ready for oral argument, which has been tentatively scheduled for September 22.  PPL’s response brief addresses in detail the considerable evidence presented to the Tax Court regarding the operation and effect of the U.K. windfall tax, arguing that the evidence conclusively shows that the tax operated like a typical U.S. excess profits tax and therefore should qualify for a foreign tax credit.  Amerian Electric Power Co. filed an amicus curiae brief in support of PPL that focuses primarily on discussing the precedents that call for courts to consider the kind of extrinsic evidence introduced by PPL.  The government’s reply brief, like the one it filed in the companion Entergy case (see here), backs away from its previous argument that the court cannot ever consider extrinsic evidence.  The government maintains, however, that PPL’s evidence was not probative and that the Tax Court should have denied creditability because the UK windfall tax describes the tax as being on “value.”

PPL – Taxpayer’s Response Brief

PPL – Amicus Brief for AEP

PPL – Government’s Reply Brief

Briefing Completed in Entergy

The government has filed its reply brief in the Fifth Circuit in Entergy.  (See our initial report on the case here.)  The reply brief puts forth a somewhat less disapproving attitude towards the examination of extrinsic evidence in foreign tax credit cases than previously advanced, stating as follows:  “The Commissioner does not contend (as he did below) that extrinsic evidence has no relevance in determining creditability under Treas. Reg. § 1.901-2(b).  Rather, our argument is that it was improper for the Tax Court to supplant an analysis of the windfall-tax statute with an analysis of extrinsic evidence.”

The bottom line, however, is the same.  The government maintains that the text of the U.K. Windfall Tax statute, by describing the tax using the term “value,” conclusively establishes that the tax is not an “income” tax in the U.S. sense and therefore is not creditable.

The case will now await an order from the Fifth Circuit setting a date for the oral argument, which is likely a few months away.

Entergy – Government’s Reply Brief

Government Brief Filed in PPL

The government has filed its brief in the Third Circuit in PPL.  The brief is virtually identical to the brief filed a few weeks ago in the Fifth Circuit in Entergy that addresses the same issue of the creditability of the U.K. Windfall Tax under Code section 901.  See our initial report here.  The only significant differences are addressing PPL’s facts instead of Entergy’s and placing more weight on Third Circuit precedent instead of Fifth Circuit precedent.  The essence of the government’s argument is that the section 901 determination should be based entirely on the text of the foreign statute, and therefore the Tax Court erred in considering extrinsic evidence of how the tax operates.  Because the U.K. statute uses the term “profit-making value,” the government says that it is a tax on “value,” not an “income” tax, and therefore it should not be creditable.

PPL’s brief is due June 9.

PPL – Government’s Opening Brief

Taxpayer Brief Filed in Entergy

The taxpayer has filed its answering brief in Entergy defending the Tax Court’s decision that the U.K. windfall tax is a creditable tax for purposes of the foreign tax credit under Code section 901.  See our original report here.  According to the taxpayer, the essence of the government’s argument is that “the creditability of a foreign tax can be determined only by the literal text of the foreign tax statute, and that the consideration of any other evidence is legal error.”  This position, the taxpayer argues, is rebutted by “overwhelming authority establishing that the predominant character of a foreign tax is measured by its intent and effect,” which requires resort to evidence beyond the text of the foreign statute. 

The taxpayer also argues that the government has mischaracterized the Tax Court’s decision in stating that the court ignored the three-part regulatory test for creditability.  Instead, the Tax Court correctly heard evidence of the intent and effect of the U.K. tax to determine its predominant character — namely, a tax on excess profits — and then applied the three-part test to that predominant character.

The government’s reply brief is due May 31.

Entergy – Taxpayer’s Answering Brief

Fifth Circuit Affirms in Container

The Fifth Circuit yesterday issued a short, unpublished opinion affirming the Tax Court’s decision in Container.  As discussed in more detail in our earlier post, the issue is the sourcing of guarantee fees charged by a Mexican parent to guarantee notes issued by its U.S. subsidiary.   The Fifth Circuit ruled that the issue turned to a considerable extent on the Tax Court’s factual findings concluding that the fees were payments for services, which it found were not clearly erroneous.  The Fifth Circuit concluded that the Tax Court’s ultimate characterization of the fees as foreign-source income was correct because they were payments for a service that was performed in Mexico — namely, the parent’s provision of the guarantee.  The government had argued that the guarantee fees were more in the nature of interest that should be sourced to the United States.

This decision is of limited significance going forward.  As we previously noted, Congress has already acted to reverse the result of this case for future years by enacting legislation specifically providing that a guarantee fee paid by a U.S. company is U.S.- sourced income.  And the opinion resists making broad pronouncements about sourcing analysis, largely confining the discussion to the facts of the case.  Indeed, by declining to publish the opinion, the Fifth Circuit has deliberately sought to minimize its precedential value.   Under Fifth Circuit Rule 47.5.4, unpublished decisions may be cited, but they “are not precedent, except under the doctrine of res judicata, collateral estoppel or law of the case.”

 A petition for rehearing, should the government choose to file one, would be due on June 16.

Government Opening Brief Filed in Entergy

The government has filed its opening brief in the Fifth Circuit in Entergy, seeking reversal of the Tax Court’s holding that the U.K. windfall tax is a “creditable” tax for purposes of the U.S. foreign tax credit.  See our previous report here.  The government argues that the Tax Court misapplied a three-part test set forth in the regulations for determining whether a foreign tax is creditable.  That test assesses whether the foreign tax has the “predominant character” of an income tax by examining whether it satisfies each of three requirements — relating to “realization,” “gross receipts,” and “net income.”  According to the government, the U.K. windfall tax did not meet any of the three requirements because the tax was imposed on “value,” not realized “income,” and because gross receipts and expenses were not “components of the tax base.”  The brief goes on to criticize the Tax Court for investigating the legislative purpose of the tax, rather than restricting its inquiry to the text of the statute.

The taxpayer’s brief is due May 16.

Entergy- Government’s Opening Brief

Briefing Schedules Line Up on UK Tax Creditability Issue

The Third Circuit has now issued a briefing schedule in the PPL case that makes the government’s opening brief due on April 5.  This schedule should have the case marching along in fairly close parallel with Entergy, the companion case presenting the same UK tax creditability issue to the Fifth Circuit.  (See our previous post here.)  In Entergy, the government recently requested an extension to file its opening brief.  The court granted an extension, but for less time than requested.  The brief is now due April 13, after a 30-day extension.   That date will likely hold, since the court has already cut back an unopposed extension request.  In PPL, by contrast, it is quite possible that the government will get some additional time.

Two Circuits to Consider Creditability of U.K. Windfall Tax

We present here a guest post from our colleague Kevin Kenworthy, who has considerable experience representing taxpayers on the issue of creditable foreign taxes.

The Tax Court’s two companion decisions in PPL Corp. v. Commissioner, 135 T.C. No. 8 (Sept. 9, 2010) and Entergy v. Commissioner, T.C. Memo 2010-166 (Sept. 9, 2010), raise an important question  concerning whether a 1997 Windfall Tax imposed by the U.K. government on previously privatized industries is a creditable income tax under U.S. rules.  The cases were tried separately before Judge Halpern and addressed in companion opinions issued simultaneously that ruled for the taxpayer (with the analysis contained in the PPL opinion).  The opinions are linked below.  The government has now appealed these cases to the Third and Fifth Circuits respectively.  (The Tax Court cases, in opinions issued a few weeks earlier, also addressed an issue concerning the appropriate recovery period for depreciation of an electric utility’s lighting assets, but it appears at this point that the government does not plan to contest that issue on appeal.)

Under section 901 of the Code and related provisions, a U.S. taxpayer can elect to credit, rather than deduct, qualifying income taxes paid to a foreign country.  Only income taxes are eligible for this credit; non-income taxes can only be deducted in computing taxable income.  In determining whether a foreign tax is creditable, the ultimate inquiry is whether the levy is an income tax in the U.S. sense of the term.  The governing regulations provide a specific framework for assessing whether a foreign tax meets this test, including requirements that the foreign tax meet a three-part test aimed at determining whether the tax will reach net gain in the ordinary circumstances in which it applies.  Treas. Reg. §  1.901-2.

The U.K. Windfall Tax is an unconventional levy in some respects, resulting in part from its unique origins in British politics.  In the early 1990s, Conservative governments continued a policy of privatizing what had previously been government-owned monopolies, including regional electricity companies, through a series of public stock offerings.  The privatizations were anathema to traditional Labour Party tenets.  Moreover, the newly privatized entities, although they continued to be subject to price regulation, proved to be quite profitable in the years following privatization.  In 1997, the new Labour government announced a tax aimed at “windfall profits” previously realized by the formerly government-owned enterprises.  The tax was justified by assertions that windfall profits resulted from the prior government’s decision to sell off the companies at too low a price, compounded by its failure to subject the privatized companies to adequate regulation.

The Windfall Tax was designed as a one-time, retrospective tax imposed on the privatized utilities.  The new tax was imposed on the basis of a unique formula that started with the average book profits of these enterprises over the first four years following privatization multiplied by nine, an amount characterized by the statute as the “value in profit-making terms.”  Tax at a rate of 23% was then imposed on the excess of this artificial earnings multiple over the initial market capitalization (the “flotation value”) of the shares.  The tax was imposed on the companies directly, rather than on the initial private shareholders, many of whom had long ago sold their shares.

The taxpayers argued that the creditability of the Windfall Tax could be established by examining the actual operation and effect of the tax.  The taxpayers showed that the statutory formula could be restated algebraically to reveal that the Windfall Tax operated in almost all cases equivalently to a tax imposed at a rate of roughly 50% on profits realized over a four-year period.  Based in large part on this equivalence, the taxpayers argued that the Windfall Tax was essentially an income tax and satisfied the regulatory test for creditability.  The IRS countered that the creditability of the Windfall Tax could be evaluated only by reference to the statutory language and that resort to extrinsic evidence of the type offered by the taxpayers was inappropriate.  Further, the IRS argued that the statute’s apparent reference to valuation principles, rather than to conventional measures of net income, leads to the conclusion that the Windfall Tax is not creditable.  Drawing ample support from the regulations themselves and from prior court decisions, the Tax Court refused to limit the creditability inquiry in this manner and found the Windfall Tax to be creditable.

The government’s opening brief in Entergy is due March 14, 2011.  No briefing schedule has yet been established in PPL.

Tax Court Decision in PPL 

Tax Court Decision in Entergy

The Curious Non-Appeal of Veritas

Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial.  The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development.  Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property).  The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.

The Tax Court held for the taxpayer in substantial part.  Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever.  This is Gunnery Sergeant Hartman’s valuation method:

Marines die, that’s what we’re here for.  But the Marine Corps lives forever.  And that means you live forever.  Full Metal Jacket (1987).

Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.

The Tax Court is correct.  The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either.  The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts.  Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former.  Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates.  Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.

In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous.  However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim.  The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas.  The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.

This attempt by the IRS to use an AOD to continue to harass taxpayers should fail.  The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments.  And it did not exclude the possibility of future product value flowing from that original IP.  Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value.  The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity.  (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.)  IP does give competitive advantages that do not necessarily disappear in next generation product developments.  However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business.  Contra Litigating Treas. Reg. § 1.482-7T.

The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences.  The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers.  If it does not believe its position merits an appeal, the IRS should accept its loss.  Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them.  As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.”  The Veritas AOD is nothing but smoke.

Conversation with Bob Kirschenbaum Regarding Great Debate

We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes.  As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco).   Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.”  After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally.  The discussion seemed interesting enough to formalize and post. 

Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?

We were prepared for either and I think Clark and I did a good job advocating.  However, I actually would have preferred the “con” position.  It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.   

With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?

It is easier in the sense that the argument can be made very simply. That is true.  The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties.   The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred. 

Personally, do you think the income method has a place in transfer pricing practice?

I think it does.  However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations.  If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP.  We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes.  Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice. 

What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?

At the end of the day, probably not much.  Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited.  Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer.  But it certainly doesn’t mean that the Income Method, properly applied, is never useful. 

What do you see as the biggest errors the IRS makes in applying the Income Method?

 (1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage.  Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations.  You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition.  Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP.  You cannot assume large growth rates decades out and try to allocate all of that value to the original IP.  At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory.  There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.

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