Why Some Foreign Stock Purchases Flunk the Tax Code Test

If you're planning to shelter capital gains generated by an ADR purchase, take a look at why Compaq's stock purchase seems to fail the tax code's economic substance test.

On September 16, 1992, 21st Securities, acting on behalf of Compaq Computer, purchased 10 million Royal Dutch Shell ADRs (American depositary receipts) from the “designated seller,” which was a client of 21st Securities. Immediately after the purchase, 21st Securities sold the ADRs back to the seller. The trades were made in 46 separate New York Stock Exchange “floor” transactions and were completed in a little over one hour. The aggregate purchase price of the ADRs was about $887.6 million “cum dividend,” or with an entitlement to the next dividend payment attached. The aggregate resale price, “ex-dividend,” was approximately $868.4 million.

As a result, Compaq realized capital gains that it wished to shelter from taxation, from other, unrelated transactions. Indeed, Compaq was the shareholder of record on the record date for the dividend and was therefore entitled to a gross dividend of some $22.5 million. About $3.4 million of Netherlands taxes was withheld from Compaq’s dividend.

On its 1992 federal income-tax return, Compaq reported about $20.7 million in capital losses; about $22.5 million in dividend income; and a foreign tax credit of about $3.4 million. The company used the capital loss to offset part of the capital gain it realized in 1992. The tax court disallowed the gross dividend income, the foreign tax credit, and the capital loss reported by company. However, the Court of Appeals for the Fifth Circuit, in a decision that has elicited numerous law-review articles both pro and con, found in favor of the company (see Compaq Computer Corporation and Subsidiaries v. Commissioner, 277 F.3d 778 (5th Cir. 2002)).

The case revolved around the question of whether the ADR transaction was imbued with economic substance. In an earlier case — Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985) — the court held that it is appropriate for a court to engage in a two-part inquiry to determine whether a transaction has economic substance or is a “sham” that must be disregarded for tax purposes. To treat a transaction as a disregardable sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and the transaction has no economic substance because “no reasonable possibility of a profit exists.”

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The appeals court noted that the tax court’s decision was “in conflict” with the decision of the Eighth Circuit Court of Appeals in IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001). There, the court concluded that in a transaction identical to the one Compaq had engaged in, both economic substance and business purpose were present.

The court rejected the argument that the taxpayer purchased only the right to the net dividend, not the gross dividend. The court said that the part of the gross dividend withheld as taxes “was as much income” to the taxpayer as the net dividend received after taxes. In fact, the court added that the discharge by a third party of an obligation is equivalent to receipt by the person taxed (see Old Colony Trust Co. v. Commissioner, 279 US 716 (1929)). Further, when the full amount of the gross dividend was counted as income, the transaction resulted in a profit.

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