PPL: Exposing the Flaws Of the Foreign Tax Credit

Download PDF On February 20 the Supreme Court heard oral arguments in PPL v. Commissioner. The Court will decide in the next fewmonths whether a windfall tax imposed by the United Kingdom on privatized utilities in 1997 falls within the category of ‘‘income, war profits, and excess profits taxes'' that qualify for the foreign tax credit under section 901. Rather than seeking to answer that question, I argue that the impossibility of providing a satisfactory answer vividly illustrates the underlying flaws of the FTC.

Much ink has been spilled debating whether the U.K. windfall tax is an income tax that qualifies for the credit or is instead a tax on asset value that does not qualify. In seeking an answer to this elusive question, both sides have relied on gossamer-thin distinctions that have little or no policy relevance to the proper U.S. tax treatment of the U.K. tax. The reliance on those distinctions highlights the underlying reality that there is no sound policy reason for the U.S. income tax system to treat foreign income taxes more generously than foreign taxes on asset values. 

One possible response, suggested by some commentators, is to broaden the set of foreign taxes that are creditable. The best reform, however, would move in the opposite direction and make all foreign taxes deductible at the tax rate imposed on foreign income, the treatment extended to other foreign business costs. Reiterating a point made a halfcentury 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 restrictionson the credit cannot satisfactorily combat those incentives.

Moreover, the credit is not the best way to achieve global cooperation to combat excessive taxation of cross-border investment. That goal is better achieved by continuing the international movement toward a regime in which capital income is taxed only at the individual level in the individual investor's country of residence.