In Compaq’s case, that argument was fairly straightforward. On September 16, 1992, the company purchased 10 million shares of ADRs in Royal Dutch Petroleum immediately prior to the company declaring a dividend. It then sold the ADRs ex-dividend the same day for a loss. The company received dividends of more than $22 million on the briefly owned investment and recorded a capital loss of just under $21 million on the sale of the stock, which offset previously incurred capital gains. It also claimed foreign tax credits of $3.4 million for taxes paid to the Netherlands government. The IRS argued that the transaction did not have the potential for profit and that the company would not have entered into it were it not for the foreign tax credits it claimed.
The company, on the contrary, argued that it had indeed made a pretax profit of $1.9 million and an aftertax profit of $1.25 million on the arbitrage transaction. The IRS treated the Netherlands tax payments as an expense of the transaction, without treating the foreign tax credits as a benefit. Judge Edith H. Jones chided the IRS for attempting to “stack the deck,” and ruled that the transaction did in fact have economic substance. “It had nothing to do with taxes,” says Twenty-First’s Gordon, who pitched the transaction to Compaq. “Most brokerage firms do it for their own account, so we offered it to clients.”
Another company to notch a court victory is United Parcel Service. Last fall, it successfully appealed a huge adverse Tax Court verdict in the 11th Circuit Court. The IRS argued that in 1983, when UPS formed a Bermuda-based subsidiary to offer insurance on packages to its customers, the transaction served no business purpose other than to confer tax-free benefits on UPS shareholders. The estimated liability of the company was $1.8 billion. UPS, however, convinced the court that the transaction did have a valid business purpose. “The state insurance commissioners were starting to exert their influence, and we didn’t want to be regulated by 50 different insurance commissioners,” says UPS spokesman Norman Black.
Other companies that had favorable verdicts last year include American Home Products and IES, a company now owned by Alliant Energy Corp. That makes the current score in court cases 7-6 for the government, with several cases still headed for appeals, says attorney Pawlow. But while the recent court victories by taxpayers may be encouraging to CFOs, they still don’t provide a clear indication of what is acceptable tax planning and what is not.
“It shouldn’t be left to the courts to sort out,” insists Pawlow. And neither new IRS rules nor tax legislation is necessarily the best answer. Many worry that new rules could have unforeseen, negative consequences for legitimate transactions.
“This is the perfect environment for the IRS and tax practitioners to think outside the box on how to resolve these issues,” says Pawlow. She suggests a fast-track mediation program and prefiling communications between taxpayers and the IRS on how a transaction will be treated for tax purposes. Nice ideas, but don’t hold your breath. For the time being, CFOs will have to continue weighing the risks and rewards of tax-saving transactions on their own.