Wednesday, February 20, 2013

Tax Case Asks Whether IRS Flip-Flopped On Key Position

  Daniel Fisher
Daniel Fisher, Forbes Staff
I cover finance, the law, and how the two interact.

For decades, the Internal Revenue Service has asked courts to look past the fancy lawyering and examine the substance of a tax-avoidance scheme. Is this really a legitimate business transaction involving an Italian manufacturing subsidiary, two Caymans corporations and a licensing entity based in the Shetland Islands, or is it just a clever way to avoid paying U.S. taxes?

Now, in a case to be argued today at the U.S. Supreme Court, the IRS is taking exactly the opposite position. And while PPL Corp. vs. IRS involves two of the driest subjects imaginable — utilities and taxes — the implications could be much larger. The case asks the high court to make a clear decision on the perennial question dogging regulators in many fields: What’s more important, form or substance?

In tax cases, “usually the goverment argues substance, not form, because the taxpayer controls the form,” said Michael Knoll, the Theodore K. Warner professor of tax policy at the University of Pennsylvania Law School.

Holding to that standard, PPL vs. IRS would appear to be a clear win for PPL. Like a lot of other U.S. utilities, the Pennsylvania company bought a U.K. subsidiary in the 1980s as the Conservative government there privatized formerly state-owned utilities. When the Liberals came to power in 1997, they decided the utilities had been sold too cheap and imposed a one-time “windfall profits tax” calculated as 23% of the excess above nine times the average daily profits of the preceding four years.

The U.S., unlike most other countries, taxes corporate profits globally. But to avoid double taxation it also allows those corporations to write off most forms of foreign income taxes. PPL argued that whatever the form, the U.K. “windfall profits” tax was a tax on its income and thus deductible. The IRS denied the deduction and PPL sued in Tax Court along with another utility, winning in 2010. The government appealed and got two different results in two different circuits, with the Fifth Circuit ruling the tax was deductible and the Third Circuit ruling it wasn’t.

A perfect set-up for Supreme Court review. A group of economists argue the economic substance of the tax should drive the result, while a group of law professors argue the law should prevail.

The U.S. Chamber and other pro-business groups argue the IRS is trying to have it both ways, typically urging courts to look past the fancy lawyering to the substance of a deal — is it really possible a $200 million offshore profit can disappear in a welter of options transactions with a Caymans subsidiary based in a lawyer’s filing cabinet? — but in this case saying the U.K. tax was not a tax on income.

“The self-serving nature of the Commissioner’s current position is a ringing alarm that betrays the arbitrariness of the government’s shifting approach,” the Southeastern Legal Foundation, the U.S. Chambers and others say in a brief supporting PPL.

Law professors at Yale, Harvard, Columbia and other prestigious schools filed a brief in favor of the IRS, however, saying if PPL prevails U.S. corporations could deduct all manner of payments to foreign governments from their taxes, providing a “road map” for those foreign governments to pull subsidies from U.S. taxpayers. They could privatize government assets on the cheap, for example, with confidence they could recover the money later by nailing U.S. buyers with a one-time tax those companies could deduct from their U.S. tax bill.

The IRS doesn’t concede any flip-flopping, of course, saying the U.K. tax was based on the value of the utilities, using a method of computing value familiar to any commercial real estate appraiser: The income potential of the property. But the difference between the two is less than clear-cut, Knoll said.
“On form, it’s a tax on value,” he said. “In substance, it’s a tax on prior earnings over a base.”

The implications go beyond one-time taxes, however. Foreign governments frequently try to dress up their taxes in other forms to help U.S. companies claim deductions, Knoll said, with one example being oil and gas “taxes” that look suspiciously like royalties for pulling hydrocarbons from the ground. The IRS typically disallows large chunks of such deductions, he said.

The form-vs-substance battle also rages over popular tax strategies like paying stiff intellectual-property licenses to foreign subsidiaries that also happen to siphon away all the profits of an otherwise lucrative business.

“Those issues have become much more important because of the importance of intellectual property in the modern economy,” Knoll said.

And hovering over this obscure tax fight is the larger question of U.S. corporate income tax policy. Even the Obama administration has conceded that U.S. corporate taxes may be too high, and while the U.S. theoretically taxes global profits that policy is easily evaded by setting up wholly owned, but legally separate, foreign units. Apple and other U.S. corporations have piled up tens of billions of dollars in foreign profits in those units that they are loathe to bring home and subject to U.S. taxes.

“Most other foreign countries don’t even attempt to tax worldwide earnings,” Knoll said. The U.S. effectively doesn’t either, given the ease of stashing profits indefinitely overseas. The court’s ruling in PPL vs. IRS won’t change that policy, but it could provide more guidance on whether tax strategies stand or fall on the letter of the law, or the laws of economics.
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