Treaty angle on PPL, the US foreign tax credit case

David Cameron has a fresh take on the PPL case which is worth a read, in yesterday's Tax Notes [gated]. He's wondering why no one has raised the US-UK tax treaty, which he thinks would resolve the creditability issue with ease.  He says:

... Because neither PPL nor Entergy raised the treaty issue, the Tax Court, the Third Circuit, and the Fifth Circuit relied solely on the requirements of section 901 and the regulations that define a creditable tax. The complete lack of any reference to the U.K.-U.S. tax treaty is extremely curious because the treaty provided more than adequate grounds to conclude that the windfall tax was creditable under U.S. law. 

...The [applicable] U.K.-U.S. tax treaty identified specific existing taxes imposed by the United Kingdom and designated them as income taxes for which a credit would be available (covered taxes).  

Importantly, covered taxes may well include foreign taxes that would not qualify as income taxes under domestic law.... 

...[T]he language describing the indirect credit under article 23(1) does not specifically refer to an "income tax" but only to a "tax paid to the United Kingdom by that corporation with respect to the profits out of which such dividends are paid." 

... The failure of the taxpayers in PPL and Entergy to raise the treaty issue is all the more curious given the IRS's recognition in a coordinated issue paper that the windfall tax involved a treaty issue.[The IRS claimed that the Windfall Tax would not be creditable because it was a one-time levy imposed on appreciation in value, but the] IRS's analysis of the treaty issue is not ... convincing. 

... The Supreme Court need not decide whether a formalistic or substantive analysis applies under section 901 because the U.K.-U.S. tax treaty provides an alternative argument -- a definition of an income tax at least as broad as that under section 901 and the application of a substantive analysis to determine if a tax satisfies that definition -- to conclude that the windfall tax is creditable based on the Tax Court's findings. 

...By ignoring the existence of the U.K.-U.S. tax treaty, the parties and the lower courts in PPL have overlooked a significant aspect of the case. The Supreme Court should not repeat their mistake.

I agree with David that the treaty argument should have been made, even though I am less convinced than he is that on substance the "windfall tax" is really even a tax at all--I think it looks like a purchase price adjustment. But that was also not an argument brought up by anyone at trial, instead the IRS conceded that the "tax" was in fact a tax. Having done so, the treaty does seem to present the more permissive regime.

But a big part of this story is David's puzzlement about the treaty being overlooked by all the parties and all the judges, despite the IRS having previously articulated a treaty-based position on the very tax in question. Can it be that the parties just assumed the treaty did not apply, or if it did apply, did not provide a different result? Can it be that they all made those assumptions without undergoing a close analysis, without doing any research?

If so David is suggesting that a big mistake has potentially been made, and if the Supreme Court rules against the taxpayer in PPL, it may have been a quite costly mistake. That's bad for the taxpayer and bad form on the part of the lawyers, but intriguingly, it also suggests that even in a top fight litigation situation like this, it is possible that the tax law experts on both sides overlooked an applicable legal regime, most likely because the regime in question involved international law rather than a statute in the tax code.

That is a fascinating observation for those of us who like to think about the rule of law as the product not of legal texts by themselves but of their dynamic implementation in practice. If a legal text exists but is ignored by the legal system, can it really be said to be law at all? David is suggesting that the US-UK treaty is a tree falling in a forest, unheard by anyone. Usually I am worried that people will imagine that they hear trees falling in forests when there are no trees at all--that is, I worry about non-legal assertions being treated as equivalent to law (for example, OECD guidelines). David's article suggests that the opposite may have happened in this case.