A windfall profits tax in the United Kingdom can be credited against US income taxes, the US Supreme Court said.

PPL Corporation, a US utility holding company, bought a 25% interest in a regional electric distribution company in Britain when the British government privatized all 12 of its regional distribution companies in 1990. The Labour party was opposed to the privatizations. After it regained control of parliament in 1997, it imposed a one-time windfall profits tax on the owners of the companies.

In form, the tax was 23% of the difference between what the Labour government felt the companies’ flotation values should have been and the prices at which they were actually sold.

US companies can claim income taxes paid on foreign earnings to other countries as a credit against US income taxes on the earnings when the earnings are repatriated to the United States. However, foreign tax credits can only be claimed for taxes whose “predominant character” is that of an “income tax in a US sense.”

The IRS argued that the taxes in this case were not income taxes because they were calculated on a hypothetical windfall for “underpaying” for shares in the privatization.

The Supreme Court analyzed the formula for calculating the tax and concluded that it was in fact a tax on actual income. What the formula did, the court said, was to calculate the amount by which a company’s actual profits over the first four years after privatization were “excess” and impose a tax on it. The actual formula was 23% times the daily average profit during the initial post-privatization period of up to four years times 365 times 9 (the price-to-earnings ratio the Labour government thought should have been used to value the companies in the privatization). It then subtracted the actual flotation price.

However, the court said the formula was mathematically the same as a 51.71% tax on the company’s actual profits over the first four years, minus what the government thought it was reasonable for the company to earn. The amount subtracted from actual earnings in the formula was mathematically equivalent to a fraction — the flotation price at which the company was sold in the privatization divided by 9 — multiplied by 4.0027. In other words, the tax was on the actual profits to the extent they exceeded an amount the government considered reasonable.

The court released its decision in late May. The case is PPL Corp. v. Commissioner. Entergy, another US utility holding company that bought London Electricity, won a similar case at the appeals court level. The Supreme Court declined to review the decision in the Entergy case.