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.

The appeals court also rejected the assertion that because the transaction carried no risk of loss, it was a sham: the court noted that some risk, albeit minimal, attended the transaction. The Fifth Circuit embraced the findings of the Eighth Circuit.

The payment of Compaq’s Netherlands obligation by Royal Dutch Shell was income to Compaq. It follows, the court concluded, that the gross dividend, not the dividend net of Netherlands taxes, should have been used to compute Compaq’s pretax profit. The tax court also erred by failing to include Compaq’s $3.4 million U.S. tax credit when it calculated the computer company’s aftertax profit. To be sure, if the effects of tax law are to be accounted for when they subtract from cash flow, tax-law effects ought to be counted when they add to such cash flow.

On this basis, Compaq made both a pretax profit and an aftertax profit from the transaction. Therefore, subtracting Compaq’s capital losses from the gross dividend (rather than the net dividend) results in a net pretax profit of $1.894 million. The company’s U.S. tax on that net pretax profit was roughly $644,000. Subtracting $644,000 from $1.894 million results in an aftertax profit of $1.25 million.1 Accordingly, the transaction had economic substance.

Moreover, the evidence does not show that Compaq’s choice to engage in the transaction was motivated solely by tax consequences. The evidence demonstrates that Compaq “actually and legitimately” also sought the pretax profit it would get from the gross dividend less the capital loss.

Although the parties attempted to minimize the risks incident to the transaction, those risks did exist and were “not insignificant.” The transaction occurred on a public market, not in an environment controlled by Compaq and its agents. The market prices could have changed (and in fact did) during the course of the transaction, any of the trades could have been broken up or been executed incorrectly, and the dividend might not have been paid or might have been paid in a different amount than Compaq anticipated.

As a result, the court found that the ADR transaction should have been recognized as valid for U.S. tax purposes. That is, the ADR transaction, in the court’s view, had both a reasonable possibility of profit attended by a real risk of loss and an adequate nontax business purpose.

Economic Substance Doctrine Codified

It seems doubtful that the ADR transaction would pass muster under the version of the economic substance doctrine contained in Section 7701(o) of the Internal Revenue Code. That section provides that in the case of a transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if the follow criteria exist:
• The transaction changes, in a material way (apart from federal tax consequences), the taxpayer’s “economic position”; and
• The taxpayer has a substantial business purpose (apart from federal tax consequences) for entering into such transaction.

The potential for profit, the statute says, is considered when determining whether these requirements are met only if the present value of the “reasonably expected” pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Moreover, the Secretary of the Treasury is directed to issue regulations requiring foreign taxes to be treated as expenses in determining pretax profit potential “in appropriate cases.” It seems clear that this latter provision, which would treat the foreign taxes imposed on Compaq as an expense in assessing the overall transaction’s profit potential, would cause the ADR transaction to flunk the revamped economic substance doctrine.2

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.


Footnotes


1 Taking the tax credit into account, Compaq owed roughly $644,000 more in worldwide tax liability as a result of the transaction than it would have owed had the transaction not occurred.
2 The ability to “strip” foreign dividends was greatly curtailed by the enactment of Section 901(k), which imposes a more than 15-day holding requirement on the stock with respect to which the dividend is paid in order to earn a foreign tax credit for any withholding tax exacted with respect to the dividend.

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