Windfall cracks: the structural flaws in taxing energy sector profits


The recent instability in the energy markets – mainly due to the Russian invasion of Ukraine – has led to a resurgence of interest in windfall taxation. Accordingly, and mainly based on a (sometimes inaccurate) reference to the category of windfall profits taxes, the Council of the European Union adopted Regulation (EU) 2022/1854 of October 6 2022, which created a temporary solidarity contribution on “excess profit as a result of unexpected circumstances”, as defined in the preamble to the regulation.

The base for calculating the TSC is the taxable profits of companies and permanent establishments that are tax resident in the EU in the crude petroleum, natural gas, coal, and refinery sectors, as determined in bilateral treaties or member states’ national tax laws for the tax year starting on or after January 1 2022 and/or January 1 2023 and for their respective full duration.

This article will analyse this solution, not only to assess its assumptions, but also the types of problems it may have in the tax systems of each member state.

The perspective of the energy tax policy

The TSC targets the profitability of EU companies and permanent establishments with activities in the crude petroleum, natural gas, coal, and refinery sectors, which has significantly increased compared with prior years.

In this context, the TSC is not exactly a windfall profit tax model, but rather a tax on excessive profits.

From a tax policy perspective, there are two principles governing the determination of excess profits:

  • The ‘war profits principle’ is designed to recapture wartime increases in profits over normal peacetime profits of the taxpayer; and

  • The ‘high profits principle’ is based on income in excess of a statutory rate of return on invested capital.

The modern excess profits tax was first instituted during World War I, as a revenue measure and an instrument of curbing excess profits generically attributable to the war. Subsequently, excess profits taxes were levied during World War II and the Korean War.

Excess profits taxes based on the high profits principle have become part of the peacetime tax structure of a few countries, but without eradicating several problems with regard to the integration of an excess profits tax within the total tax structure of a country, particularly in relation to existing corporate income taxes and the determination of what is, or should be, ‘excess’.

The main problem with the TSC model is that it mixes the war profits principle and the high profits principle. If, on the one hand, it taxes sectors that have had a relative increase in profits in the past year, on the other hand, the criterion used by the regulation has no relation with the statutory rate of return on invested capital and, therefore, with the risk profile of each activity.

Article 15 of the regulation prescribes that the TSC should be “calculated on the taxable profits, as determined under national tax rules, in the fiscal year 2022 and/or the fiscal year 2023 and for their full duration, which are above a 20% increase of the average of the taxable profits, as determined under national tax rules, in the four fiscal years starting on or after 1 January 2018”.

That is, if the profits of 2022 and/or 2023 are 20% higher than the profits of the period 2018–21 (in terms of tax years), the part of the profits above that percentage will be considered as excessive and taxed at a minimum of 33%.

This type of criterion has an additional problem, now from a tax policy perspective: it includes, for the relevant four-year profits average (2018–21), years in which the profits of the sectors charged with the TSC were negatively affected by the COVID pandemic, as evidenced by data from the International Energy Agency and the OECD.

The absence of any criterion or sub-criterion that ‘discounts’ the effect of the ‘excessive’ decrease in profits during the pandemic makes the TSC model necessarily inflated, because it considers the average of profits between 2018 and 2021 as ‘normal’, which does not technically correspond to reality.

Ultimately, the TSC model turns out to be incompatible with the war profits principle, given that the regulation adopts the 2018–21 interval as a normal period, within which is a period that is also closer to a war, the pandemic itself.

This type of problem would be avoided through a more practical and transparent solution, especially given that European-wide corporate income tax structures are already based on flat rates, which can be complemented with surcharges if necessary.

Energy transition and capital allocation maximisation

In addition to the tax policy problems, the introduction of the TSC also burdens sectors that are highly committed to energy transition.

Therefore, in addition to the economic and policy issues raised, as well as the tax–legal issues that may arise in each member state (some, with constitutional relevance), it may be expected that some of the market players most affected by the impact of the TSC may reduce their predisposition to accelerating their energy transition.

From this perspective, this measure does not seem to have been timely, because there is no reason why it should not be the market, and not any other institution or organisation, that balances the supply and demand positions.

Short-term (or cyclical) taxes, as is necessarily the case with the TSC, are not very successful solutions in the history of tax policy. The main reason is that windfall profit taxes, as well as excess benefits taxes, are conceptually contrary to the liberalised (albeit regulated) nature of most sectors of economic activity in EU member states.

In addition, there is no empirical evidence that the introduction of this type of tax has an impact on the main problem underlying energy inflation and its relationship with the well-being of final consumers: the demand for energy is, according to most economic models, basically inelastic; i.e., it often remains constant despite price changes.

In this sense, it cannot be excluded that, at the national level, litigation may arise around the TSC, depending on the constitutional particularities in each member state.

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