WINDFALL PROFIT TAXES that US utilities paid in the United Kingdom cannot be used as an offset against US taxes, the IRS said in a “coordinated issues paper.”

The agency made the paper public in late July. The utilities own shares in UK regional electric companies that the British government privatized in the early 1990s. The British government collected a one-time tax on the “windfall profits” that the owners of the privatized companies earned due to the initial bump up in share prices after privatization. The tax had to be paid in two installments in 1997 and 1998.

US utilities that paid these taxes tried to claim them as foreign tax credits in the United States. Only “income taxes” may be credited. The IRS asserts in the coordinated issues paper that the UK windfall profit tax fails because it was a tax on hypothetical appreciation in value of the regional electric companies — rather than on actual gains — and the British government did not wait to collect the levy until the shareholders “realized” their gains by selling shares.

The IRS also rejected the argument that the US-UK tax treaty requires the US to allow the taxes as a foreign tax credit. The issue is whether the windfall profit tax is “substantially similar” to several taxes that are enumerated in the treaty. The IRS said it is not.

The UK government imposed a windfall profit tax in 1997 on shareholders of the privatized companies. The tax was 23% of the appreciation in value of each company since privatization. The appreciation was calculated by comparing the amount paid for the shares at privatization to the company’s “value . . . in profit making terms.” This was defined as nine times the company’s average annual after-tax profits in the four years immediately following privatization.

The issue is expected to end up in court. Some commentators have suggested US utilities might have a claim against the UK government for expropriation.

Keith Martin