UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
_______________________
No. 00-60648
_______________________
COMPAQ COMPUTER CORPORATION AND SUBSIDIARIES,
Petitioner-Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
_________________________________________________________________
Appeal from a Decision
of the United States Tax Court
_________________________________________________________________
December 28, 2001
Before JONES, SMITH, and DeMOSS, Circuit Judges.
EDITH H. JONES, Circuit Judge:
In this case, Compaq Computer Corporation engaged in a
foreign stock transaction involving the purchase and resale of
American Depository Receipts (ADRs). The Tax Court held that
because the ADR transaction lacked economic substance, the
transaction should be disregarded for federal income tax purposes.
113 T.C. 214 (1999). The Eighth Circuit recently decided the same
question and concluded as a matter of law that ADR transactions of
the sort at issue here have economic substance and a business
purpose. We agree with the Eighth Circuit’s conclusion and
reverse.
BACKGROUND
The facts are stated in the opinion of the Tax Court and
are set out only briefly here. An ADR is a trading unit, issued by
a trust, that represents ownership of stock in a foreign
corporation. Foreign stocks are customarily traded on U.S. stock
exchanges using ADRs. An ADR transaction of the kind at issue in
this case begins with the purchase of ADRs with the settlement date
at a time when the purchaser is entitled to a declared dividend --
that is, before or on the record date of the dividend. The
transaction ends with the immediate resale of the same ADR with the
settlement date at a time when the purchaser is no longer entitled
to the declared dividend -- that is, after the record date. In the
terminology of the market, the ADR is purchased “cum dividend” and
resold “ex dividend.”
Twenty-First Securities Corporation, an investment firm
specializing in arbitrage transactions, proposed to Compaq that
Compaq engage in an ADR transaction. Compaq’s assistant treasurer,
James Tempesta, and treasurer, John Foster, had a one-hour meeting
with Twenty-First to discuss this possibility. After a discussion
among Tempesta, Foster, and Compaq’s chief financial officer,
Darryl White, it was decided to go forward with an ADR transaction.
Tempesta did not perform a cash-flow analysis before agreeing to
2
the transaction. His investigation of the transaction and of
Twenty-First was limited to telephoning a reference and reviewing
a Twenty-First spreadsheet analyzing the transaction.
The securities chosen for the transaction were ADR shares
of Royal Dutch Petroleum Company. Compaq knew little or nothing
about Royal Dutch other than generally available market
information. Without involving Compaq, Twenty-First chose both the
sizes and prices of the trades and the identity of the company that
would sell the ADRs to Compaq.
On September 16, 1992, Twenty-First, acting on Compaq’s
behalf, bought ten million Royal Dutch ADRs from the designated
seller, which was another client of Twenty-First. Twenty-First
immediately sold the ADRs back to the seller. The trades were made
in 46 separate New York Stock Exchange (NYSE) floor transactions --
23 purchase transactions and 23 corresponding resale transactions
-- of about 450,000 ADRs each and were all completed in a little
over an hour. Any trader on the floor was able to break up any of
these transactions by taking part or all of the trade; but none, it
appears, did. Because the trades were completed at market prices,
no trader had an incentive to break up the transaction. The
aggregate purchase price was about $887.6 million, cum dividend.
The aggregate resale price was about $868.4 million, ex dividend.
Commissions, margin account interest, and fees were about $1.5
million. Pursuant to special NYSE settlement terms, the purchase
3
trades were formally settled on September 17. Pursuant to regular
NYSE terms, the resale trades were settled on September 21. Compaq
used a margin account with Bear Stearns & Co., a well known
securities brokerage firm. Compaq was the shareholder of record of
the ADRs on the dividend record date and was therefore entitled to
a gross dividend of about $22.5 million. About $3.4 million in
Netherlands tax was withheld from Compaq’s dividend by Royal Dutch
and paid to the Netherlands government. The net dividend, about
$19.2 million, was paid directly to Compaq.
On its 1992 U.S. income tax return, Compaq reported about
$20.7 million in capital losses on the purchases and resales, about
$22.5 million in gross dividend income, and a foreign tax credit of
about $3.4 million for the Netherlands tax withheld from the gross
dividend. Compaq used the capital loss to offset part of a capital
gain of about $231.7 million that Compaq had realized in 1992 from
the sale of stock in another company.
The Commissioner sent a notice of deficiency to Compaq
for its federal income taxes that cited, among other things, the
Royal Dutch transaction. Compaq filed a petition in the Tax Court
for redetermination of the deficiencies and of an accuracy-related
penalty for negligence asserted for 1992 under Internal Revenue
Code (26 U.S.C.) § 6662. Concluding that the transaction should be
disregarded for U.S. income tax purposes, the court upheld the
deficiencies and the negligence penalty. The court disallowed the
4
gross dividend income, the foreign tax credit, and the capital
losses reported by Compaq on its tax return. Compaq then argued
that it should at least be allowed to deduct the out of pocket
losses -- commissions, margin account interest, and fees -- that it
had incurred in the course of the transaction, but the court held
that the expenses could not be deducted. Compaq appealed.
STANDARD OF REVIEW
This court reviews the Tax Court’s conclusions of law de
novo and its factual findings for clear error. See Frank Lyon Co.
v. United States, 435 U.S. 561, 581 n.16, 98 S. Ct. 1291, 1302 n.16
(1978); Chamberlain v. Comm’r, 66 F.3d 729, 732 (5th Cir. 1995).
The Tax Court’s determinations of mixed questions of law and fact
are subject to de novo review. See Jones v. Comm’r, 927 F.2d 849,
852 (5th Cir. 1991). In particular, “legal conclusion[s]” that
transactions are shams in substance are reviewed de novo.
Killingsworth v. Comm’r, 864 F.2d 1214, 1217 (5th Cir. 1989). See
Frank Lyon Co., 435 U.S. at 581 n.16, 98 S. Ct. at 1302 n.16 (“The
general characterization of a transaction for tax purposes is a
question of law subject to review. The particular facts from which
the characterization is to be made are not so subject.”).1 This is
1
Decisions such as Freytag v. Comm’r, 904 F.2d 1011, 1015-16 (5th Cir.
1990), aff’d on other grounds, 501 U.S. 868, 111 S. Ct. 2631 (1991), state that
this court reviews findings that transactions are shams for clear error. In
keeping with Frank Lyon Co., we read such statements as referring only to genuine
factual findings (e.g., a finding that a transaction was a “sham in fact,” that
is, that the transaction never occurred, see Killingsworth, 864 F.2d at 1216 &
n.3; James v. Comm’r, 899 F.2d 905, 908 n.4 (10th Cir. 1990)), not to conclusions
of law. See Killingsworth, 864 F.2d at 1217; Sacks v. Comm’r, 69 F.3d 982, 986
5
true even though the Tax Court has characterized some of its
determinations as “ultimate findings of fact.” 113 T.C. at 219.
See Ratanesan v. Cal. Dep’t of Human Servs., 11 F.3d 1467, 1469 (9th
Cir. 1993).
DISCUSSION
“[W]here . . . there is a genuine multiple-party
transaction with economic substance which is compelled or
encouraged by business or regulatory realities, is imbued with
tax-independent considerations, and is not shaped solely by
tax-avoidance features that have meaningless labels attached, the
Government should honor the allocation of rights and duties
effectuated by the parties.” Frank Lyon Co., 435 U.S. at 583-84,
98 S. Ct. at 1303-04. See Holladay v. Comm’r, 649 F.2d 1176, 1179
(5th Cir. Unit B Jul. 1981) (“[T]he existence of a tax benefit
resulting from a transaction does not automatically make it a sham
as long as the transaction is imbued with tax-independent
considerations.”), cited in Merryman v. Comm’r, 873 F.2d 879, 881
(5th Cir. 1989). The Government has stipulated that aside from its
contention that the Royal Dutch transaction lacked economic
substance, it has no objection to how Compaq chose to report its
tax benefits and liabilities concerning the transaction.
(9th Cir. 1995); James, 899 F.2d at 909 & n.5.
6
In Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89
(4th Cir. 1985), the court held that after Frank Lyon Co., 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 should not be recognized for income tax purposes. “To treat
a transaction as a sham, the court must find that the taxpayer was
motivated by no business purposes other than obtaining tax benefits
in entering the transaction, and that the transaction has no
economic substance because no reasonable possibility of a profit
exists.” Id. at 91 (emphasis added). See id. (“[S]uch a test
properly gives effect to the mandate of the Court in Frank Lyon
that a transaction cannot be treated as a sham unless the
transaction is shaped solely by tax avoidance considerations.”)
(emphasis added). Other courts have said that business purpose and
reasonable possibility of profit are merely factors to be
considered in determining whether a transaction is a sham. See,
e.g., ACM Partnership v. Comm’r, 157 F.3d 231, 247 (3d Cir. 1998)
(“[T]hese distinct aspects of the economic sham inquiry do not
constitute discrete prongs of a ‘rigid two-step analysis,’ but
rather represent related factors both of which inform the analysis
of whether the transaction had sufficient substance, apart from its
tax consequences, to be respected for tax purposes.”) (citation
omitted); James v. Comm’r, 899 F.2d 905, 908-09 (10 th Cir. 1990).
Because we conclude that the ADR transaction in this case had both
7
economic substance and a business purpose, we do not need to decide
today which of these views to adopt.
The Tax Court reasoned that Compaq’s ADR transaction had
neither economic substance nor a non-tax business purpose. The
court first concluded that Compaq had no reasonable opportunity for
profit apart from the income tax consequences of the transaction.
The court reached this conclusion by employing a curious method of
calculation: in computing what it called Compaq’s net “cash flow”
from the transaction, the court assessed neither the transaction’s
pre-tax profitability nor its post-tax profitability. Instead, the
court assessed profitability by looking at the transaction after
Netherlands tax had been imposed but before considering U.S. income
tax consequences. The court subtracted Compaq’s $20.7 million in
capital losses, not from the $22.5 million gross dividend, but from
the $19.2 million net dividend.2 The court then ignored the $3.4
million U.S. foreign tax credit that Compaq claimed corresponding
to the $3.4 million Netherlands tax. Put otherwise, in determining
whether the ADR transaction was profitable, the court treated the
Netherlands tax as a cost of the transaction, but did not treat the
corresponding U.S. tax credit as a benefit of the transaction. The
2
The Tax Court did this even though the Government had admitted that
according to generally accepted accounting principles (to which the Government
cited no exceptions), the entire amount of the gross dividend must be reported
as income.
8
result of this half pre-tax, half after-tax calculation was a net
loss figure of roughly $1.5 million.
The court rejected Compaq’s argument that it had a profit
prior to the assessment of tax.
[Compaq] used tax reporting strategies to give the
illusion of profit, while simultaneously claiming a tax
credit in an amount (nearly $3.4 million) that far
exceeds the U.S. tax (of $640,000) attributed to the
alleged profit, and thus is available to offset tax on
unrelated transactions. . . . By reporting the gross
amount of the dividend, when only the net amount was
received, petitioner created a fictional $1.9 million
profit as a predicate for a $3.4 million tax credit.
113 T.C. at 222. The court said that the intention and effect of
the transaction were to capture a tax credit, not substantive
ownership of Royal Dutch ADRs, and that the transaction had been
arranged so as to minimize the risks associated with it. See id.
at 223-24.
As for Compaq’s business purpose, the Tax Court concluded
that Compaq was motivated only by the expected tax benefits of the
ADR transaction. Among other things, the court said, Compaq had
not engaged in a businesslike evaluation of the transaction. See
id. at 224-25.
The Tax Court’s decision is in conflict with IES Indus.,
Inc. v. United States, 253 F.3d 350 (8th Cir. 2001).3 In IES, the
3
The Tax Court’s decision in this case has been subject to extensive
commentary, friendly and not so friendly. See, e.g., Marc D. Teitelbaum, Compaq
Computer and IES Industries -- The Empire Strikes Back, 20 Tax Notes Int’l 791
(2000) (disagreeing sharply with Tax Court); David P. Hariton, Sorting Out the
Tangle of Economic Substance, 52 Tax Law. 235, 273 (1999) (“. . . I am not sure
9
court held as a matter of law that an ADR transaction identical to
this one was not a sham transaction for income tax purposes.4
Undertaking the two-part inquiry set out in Rice’s Toyota World,
752 F.2d at 91-92, the court declined to decide whether a
transaction would be a sham if either economic substance or
business purpose, but not both, was present. See IES, 253 F.3d at
353-54. Instead, the court concluded that both economic substance
and business purpose were present in the transaction before it.
Turning first to economic substance, the court rejected
the argument that the taxpayer purchased only the right to the net
dividend, not the gross dividend. “[T]he economic benefit to IES
was the amount of the gross dividend, before the foreign taxes were
paid. IES was the legal owner of the ADRs on the record date. As
such, it was legally entitled to retain the benefits of ownership,
Compaq is getting away with enough in this transaction for a court to disallow
the results for lack of economic substance; to find otherwise might represent too
great an incursion into our objective system for determining tax liabilities.”);
Peter C. Canellos, A Tax Practitioner's Perspective on Substance, Form and
Business Purpose in Structuring Business Transactions and in Tax Shelters, 54 SMU
L. Rev. 47, 54 (2001) (“Transactions involving . . . foreign tax-credits on
dividend-stripping transactions exist in the hinterland between merely aggressive
transactions and tax shelters, the border crossed as artificiality increases and
tax benefits become more unreasonable.”) (footnote omitted); George K. Yin,
Getting Serious About Corporate Tax Shelters: Taking a Lesson From History, 54
SMU L. Rev. 209, 222 (2001) (answer to question whether Compaq transaction should
be disallowed for tax purposes “may not be so easy after all”); David P. Hariton,
Tax Benefits, Tax Administration, and Legislative Intent, 53 Tax Law. 579, 609
(2000) (Compaq was “rightly decided [by the Tax Court] perhaps, but without a
clear analysis”); Daniel N. Shaviro, Economic Substance, Corporate Tax Shelters,
and the Compaq Case, 88 Tax Notes 221 (2000) (generally endorsing Tax Court’s
approach); David A. Weisbach, The Failure of Disclosure as an Approach to
Shelters, 54 SMU L. Rev. 73, 79 (2001) (“I think the[ Compaq] transaction[] w[as]
clearly in the shelter camp.”).
4
The Commissioner concedes that the transaction at issue in IES is
identical to that at issue in this case.
10
that is, the dividends due on the record date.” Id. at 354. The
court said that the part of the gross dividend withheld as taxes by
the Dutch government was as much income to the taxpayer as the net
dividend remaining after taxes. The court relied on the venerable
principle, articulated in Old Colony Trust Co. v. Comm’r, 279 U.S.
716, 729, 49 S. Ct. 499, 504 (1929), that “[t]he discharge by a
third person of an obligation to him is equivalent to receipt by
the person taxed.” In Old Colony Trust Co., the Supreme Court held
that when an employer pays an employee’s income taxes, the payment
of the taxes constitutes income to the employee. Similarly, in
Diedrich v. Comm’r, 457 U.S. 191, 199-200, 102 S. Ct. 2414, 2420
(1982), the Court held that when a donor of a gift of property
conditions the gift on the donee’s paying the gift tax owed by the
donor on the gift, the donee’s payment of the donor’s gift tax
obligation constituted income to the donor.
The IES court saw no reason why the Old Colony Trust Co.
principle should not apply to the payment of foreign tax by
withholding. “The foreign corporation’s withholding and payment of
the tax on IES’s behalf is no different from an employer[’s]
withholding and paying to the government income taxes for an
employee: the full amount before taxes are paid is considered
income to the employee.” IES, 253 F.3d at 354. When the full
amount of the gross dividend was counted as income to the taxpayer,
the transaction resulted in a profit to the taxpayer. See id.
11
As for business purpose, the court said that “[a]
taxpayer’s subjective intent to avoid taxes . . . will not by
itself determine whether there was a business purpose to a
transaction.” Id. at 355. Compare Holladay, 649 F.2d at 1179.
The court rejected the Government’s argument that because the ADR
transaction carried no risk of loss, it was a sham. The court
noted that some risk, minimal though it may have been, attended the
transaction. That the taxpayer had tried to reduce the risks did
not make it a sham. “We are not prepared to say that a transaction
should be tagged a sham for tax purposes merely because it does not
involve excessive risk. IES’s disinclination to accept any more
risk than necessary in these circumstances strikes us as an
exercise of good business judgment consistent with a subjective
intent to treat the ADR trades as money-making transactions.” IES,
253 F.3d at 355.
The court further noted that the ADR transactions had not
been conducted by alter egos or by straw entities created by the
taxpayer simply for the purpose of facilitating the transactions.
Instead, “[a]ll of the parties involved . . . were entities
separate and apart from IES, doing legitimate business before IES
started trading ADRs and (as far as we know) continuing such
legitimate business after that time.” Id. Each individual ADR
trade was an arm’s-length transaction. See id. at 356.
12
We agree with the IES court and conclude that the Tax
Court erred as a matter of law by disregarding the gross amount of
the Royal Dutch dividend and thus ignoring Compaq’s pre-tax profit
on the ADR transaction. We add the following comments.
First, as to economic substance: the Commissioner does
not explain why the Old Colony Trust Co. principle does not apply
here. That the tax was imposed by the Netherlands rather than by
the United States, or that it was withheld rather than paid at the
end of the tax year, is irrelevant to how the part of the dividend
corresponding to the tax should be treated for U.S. income tax
purposes. Pre-tax income is pre-tax income regardless of the
timing or origin of the tax. See Old Colony Trust Co., 279 U.S. at
729, 49 S. Ct. at 504 (“It is . . . immaterial that the taxes were
directly paid over to the government [by the taxpayer’s employer,
rather than by the taxpayer].”); Riggs Nat’l Corp. v. Comm’r, 163
F.3d 1363, 1365 (D.C. Cir. 1999) (“In calculating his United States
tax liability, the lender must include in gross income the interest
payment he receives from the borrower and the Brazilian tax paid
(on his behalf) by the borrower to the Brazilian tax collector.”);
Reading & Bates Corp. v. United States, 40 Fed. Cl. 737, 750 (1998)
(“The indemnification agreement at issue results in taxable income
to plaintiff because it contractually discharges plaintiff's
13
Egyptian tax obligation.”).5 Because Compaq was entitled to
payment of the dividend as of the record date, Compaq was liable
for payment of tax on the dividend; accordingly, the payment of
Compaq’s Netherlands tax obligation by Royal Dutch was income to
Compaq. See 113 T.C. at 219 ($3.4 million payment to Netherlands
“represent[ed] withholding amounts for dividends paid to U.S.
residents” under treaty between U.S. and Netherlands); IES, 253
F.3d at 351-52, 354; Treas. Reg. § 1.901-2(f)(1) ("The person by
whom tax is considered paid for purposes of [the foreign tax credit
provisions of the Revenue Code] is the person on whom foreign law
imposes legal liability for such tax, even if another person (e.g.,
a withholding agent) remits such tax."); Treas. Reg. §
1.901-2(f)(2)(i) (“Tax is considered paid by the taxpayer even if
another party to a direct or indirect transaction with the taxpayer
agrees, as a part of the transaction, to assume the taxpayer’s
foreign tax liability.”). Indeed, the Commissioner admitted in
this case that according to generally accepted accounting
principles, the entire amount of Compaq’s gross dividend must be
reported as income. If the $3.4 million had been paid to the
United States (whether by withholding or at the end of the tax
year) instead of the Netherlands, there would have been no argument
5
Indeed, the Internal Revenue Service has stated in a revenue ruling
that “United States shareholders of foreign corporations should report, for
Federal income tax purposes, the gross amount of dividends received from such
corporations without reduction for withholding of the foreign income tax
thereon.” Rev. Rul. 57-516, 1957-2 C.B. 435.
14
that this money was not income to Compaq. It follows that the
gross Royal Dutch dividend, not the dividend net of Netherlands
tax, should have been used to compute Compaq’s pre-tax profit.
The Tax Court also erred by failing to include Compaq’s
$3.4 million U.S. tax credit when it calculated Compaq’s after-tax
profit. 113 T.C. at 223. This omission taints the court’s
conclusion that the “net economic loss” from the transaction after
tax was about $1.5 million. If the effects of tax law, domestic or
foreign, are to be accounted for when they subtract from a
transaction’s net cash flow, tax law effects should be counted when
they add to cash flow. To be consistent, the analysis should
either count all tax law effects or not count any of them. To
count them only when they subtract from cash flow is to stack the
deck against finding the transaction profitable.6 During this
litigation, the I.R.S. has consciously chosen to try to stack the
deck this way. See I.R.S. Notice 98-5, 1998-1 C.B. 334 ("In
general, reasonably expected economic profit will be determined by
taking into account foreign tax consequences (but not U.S. tax
consequences) [of transactions]. . . . In general, expected
6
The Tax Court’s assertion that “[i]f we follow [Compaq]’s logic, .
. . we would conclude that [Compaq] paid approximately $4 million in worldwide
income taxes on . . . $1.9 million in profit” suffers from the same flaw. 113
T.C. at 222. When Compaq’s $3.4 million U.S. tax credit is counted in the
calculation, Compaq’s net worldwide tax liabilities arising from the transaction
amount only to $644,000. In addition, the assertion ignores the fact that only
about $644,000 of the $4 million was paid on Compaq's $1.9 million pre-tax
profit. The rest of the $4 million was not paid on the profit; rather, the tax
was paid (to the Netherlands) on the gross amount of the Royal Dutch dividend.
15
economic profit will be determined by taking into account expenses
associated with an arrangement, without regard to whether such
expenses are deductible in determining taxable income. For
example, in determining economic profit, foreign taxes will be
treated as an expense."). The Commissioner, however, has provided
no reason to endorse its approach and ignore Old Colony Trust Co.7
That the Government would get more money from taxpayers does not
suffice.
To un-stack the deck and include the foreign tax credit
in calculating Compaq’s after-tax profit from the Royal Dutch
transaction does not give Compaq a windfall. The purpose of the
Revenue Code’s foreign tax credit provisions is to reduce
international double taxation. See, e.g., Norwest Corp. v. Comm’r,
69 F.3d 1404, 1407 (8th Cir. 1995). Compaq reported its gross Royal
Dutch dividend income to both the United States and the
Netherlands. Without the tax credit, Compaq would be required to
pay tax twice -- first to the Netherlands through withholding on
the gross dividend, and then to the United States -- on the same
dividend income. Taking the tax credit into account, Compaq owed
roughly $644,000 more in worldwide income tax liability as a result
of the transaction than it would have owed had the transaction not
occurred. Although the United States lost $2.7 million in tax
7
At oral argument, counsel for the Government admitted that he had
found no case supporting the proposition that foreign tax on a transaction should
be treated as an expense in determining whether the transaction was profitable.
16
revenues as a result of the transaction, that is only because the
Netherlands gained $3.4 million in tax revenues.
If the effects of the transaction are computed
consistently, Compaq made both a pre-tax profit and an after-tax
profit from the ADR transaction. Subtracting Compaq’s capital
losses from the gross dividend rather than the net dividend results
in a net pre-tax profit of about $1.894 million. Compaq’s U.S. tax
on that net pre-tax profit was roughly $644,000. Subtracting
$644,000 from the $1.894 million results in an after-tax profit of
about $1.25 million. The transaction had economic substance.
Second, as to business purpose: even assuming that Compaq
sought primarily to get otherwise unavailable tax benefits in order
to offset unrelated tax liabilities and unrelated capital gains,
this need not invalidate the transaction. See Frank Lyon Co., 435
U.S. at 580, 98 S. Ct. at 1302 (“The fact that favorable tax
consequences were taken into account by Lyon on entering into the
transaction is no reason for disallowing those consequences. We
cannot ignore the reality that the tax laws affect the shape of
nearly every business transaction.”) (footnote omitted); Holladay,
649 F.2d at 1179; ACM Partnership, 157 F.3d at 248 n.31 (“[W]here
a transaction objectively affects the taxpayer’s net economic
position, legal relations, or non-tax business interests, it will
not be disregarded merely because it was motivated by tax
considerations.”); Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.
17
1934) (Hand, J. Learned) (“Any one may so arrange his affairs that
his taxes shall be as low as possible; he is not bound to choose
that pattern which will best pay the Treasury; there is not even a
patriotic duty to increase one's taxes."), aff'd, 293 U.S. 465, 55
S. Ct. 266 (1935).8 Yet the evidence in the record does not show
that Compaq’s choice to engage in the ADR transaction was solely
motivated by the tax consequences of the transaction. Instead, the
evidence shows that Compaq actually and legitimately also sought
8
In particular, the fact that Compaq had a large unrelated capital
gain in 1992 does not mean that Compaq had an impermissible motive in seeking to
engage in the transaction. The capital gain, of course, made it possible for
Compaq to obtain an otherwise unavailable tax benefit from the ADR transaction
by offsetting its $20.7 million in capital losses from the transaction against
the gain. 26 U.S.C. § 1211(a) (corporation’s “losses from sales or exchanges of
capital assets shall be allowed only to the extent of gains from such sales or
exchanges”); Circle K Corp. v. United States, 23 Cl. Ct. 665, 670 (1991). If
Compaq had had no capital gain whatsoever in 1992, it would still have had to pay
tax on the gross amount of its $22.5 million dividend from Royal Dutch, which --
in the absence of a capital gain against which to offset its capital losses --
would have resulted in a substantial after-tax loss to Compaq. But cf. 26 U.S.C.
§ 1212 (allowing for certain carrybacks and carryovers of capital losses against
capital gains realized in years different from the years in which the losses were
realized); Circle K Corp., 23 Cl. Ct. at 670. Put otherwise, the availability
of a capital gain against which to offset the capital losses from the ADR
transaction was a necessary precondition to the profitability of the transaction
on an after-tax basis. A sensible taxpayer would have engaged in such a
transaction only if it had a capital gain against which to offset the capital
losses that the taxpayer knew would result from the transaction. All this is
unremarkable and is no evidence that Compaq had an impermissible motive.
According to the Commissioner, tax-exempt organizations with no use
for U.S. income tax credits have an incentive to loan out their ADRs to
non-tax-exempt persons in transactions of the kind at issue in this case. The
non-exempt persons can use the capital losses and tax credits resulting from ADR
transactions to offset unrelated capital gains and tax liabilities. The fact
that the differing tax attributes of investors make ADRs more valuable for some
investors than for others does not deprive ADR transactions of economic substance
for purposes of the tax laws. The possible benefits from ADR transactions for
investors with unrelated capital gains and tax liabilities are analogous to the
benefits that taxpaying investors (especially investors with high incomes), but
not tax-exempt persons, get from the purchase of tax-exempt bonds with lower
yields than the pre-tax yields available from non-exempt bonds. See Yin, supra,
at 222-23. In both instances the benefits would not exist were it not for the
investors’ individual tax attributes.
18
the (pre-tax) $1.9 million profit it would get from the Royal Dutch
dividend of approximately $22.5 million less the $20.7 million or
so in capital losses that Compaq would incur from the sale of the
ADRs ex dividend.
Although, as the Tax Court found, the parties attempted
to minimize the risks incident to the transaction, those risks did
exist and were not by any means insignificant. The transaction
occurred on a public market, not in an environment controlled by
Compaq or its agents. The market prices of the ADRs could have
changed during the course of the transaction (they in fact did
change, 113 T.C. at 218); any of the individual trades could have
been broken up or, for that matter, could have been executed
incorrectly; and the dividend might not have been paid or might
have been paid in an amount different from that anticipated by
Compaq. See IES, 253 F.3d at 355. The absence of risk that can
legitimately be eliminated does not make a transaction a sham, see
id.; but in this case risk was present. In light of what we have
said about the nature of Compaq’s profit, both pre-tax and post-
tax, we conclude that the transaction had a sufficient business
purpose independent of tax considerations.9
9
In IES, the court noted the Tax Court’s assertion in this case that
in light of Compaq’s limited investigation of the risks of the Royal Dutch
transaction, Compaq had had no non-tax business purpose in agreeing to the
transaction. 253 F.3d at 355. Even if we agreed with the Tax Court that Compaq
had not adequately investigated the risks, it would not make a difference to the
outcome of this case. Though Compaq could have done more to evaluate the risks
of the transaction, the process it used does not alone prove a lack of business
purpose for a transaction that had real risks. It should also be noted that in
19
Because the Royal Dutch ADR transaction had both economic
substance and a non-tax business purpose, it should have been
recognized as valid for U.S. income tax purposes. This court’s
decisions applying the economic substance doctrine to disregard
various transactions are not to the contrary. Without enumerating
all of the decisions, we mention some to give a flavor of the
differences between the facts at issue in the decisions and in this
case. In Freytag v. Comm’r, 904 F.2d 1011 (5th Cir. 1990), aff’d
on other grounds, 501 U.S. 868, 111 S. Ct. 2631 (1991), this court
affirmed a Tax Court decision disallowing losses allegedly incurred
as a result of investments in a commodity straddle program. The
taxpayers’ investment agent had “absolute authority over the
pricing and timing of the transactions” at issue, which “occurred
in [a] self-contained market of its own making.” 904 F.2d at
1016.10 In Merryman, a business partnership was disregarded for tax
purposes because “the formation and role of the partnership served
no other purpose except tax avoidance;” a number of facts found by
the Tax Court indicated that the partnership lacked economic
this case, as in IES, the taxpayer declined to go forward with all of the
transactions that Twenty-First had proposed. See 113 T.C. at 216; IES, 253 F.3d
at 355.
10
Similarly, in Fender v. United States, 577 F.2d 934, 937 (5th Cir.
1978), the taxpayers’ sale-and-repurchase transactions involving bonds were not
recognized where the taxpayers had “sufficient influence” over the other party
to the transaction to “remove any substantial risk” that they would be unable to
recapture their apparent losses from the sale of the bonds by repurchasing the
bonds. And in Salley v. Comm’r, 464 F.2d 479 (5th Cir. 1972), this court held
that interest payments made by the taxpayers on loans from an insurance company
that they controlled were not deductible. See id. at 480.
20
reality and was a mere formality. See id. at 881-83. In
Killingsworth, this court affirmed a Tax Court decision concluding
that a scheme of option hedge or option straddle transactions
lacked economic substance. We relied on Revenue Code section 108,
a provision that is not relevant to this case, and noted that the
transactions “appear[ed] to be devoid of profit making potential.”
864 F.2d at 1218. In Holladay, this court affirmed the Tax Court’s
decision to disallow half of certain tax benefits that an agreement
between two joint venturers allocated to only one of the venturers.
The allocation had no valid non-tax business purpose. 649 F.2d at
1180. Compare Boynton v. Comm’r, 649 F.2d 1168, 1173-74 (5th Cir.
Unit B Jul. 1981).
In this case, by contrast, the ADR transaction had both
a reasonable possibility of profit attended by a real risk of loss
and an adequate non-tax business purpose. The transaction was not
a mere formality or artifice but occurred in a real market subject
to real risks. And, as has been discussed, the transaction gave
rise to a real profit whether one looks at the transaction prior to
the imposition of tax or afterwards.
For the foregoing reasons, the Tax Court erred as a
matter of law in disallowing Compaq’s identification of gross
dividend income, a foreign tax credit, and capital losses
associated with the Royal Dutch ADR arbitrage transaction. It is
unnecessary to reach the alternative arguments for reversal offered
21
by Compaq: first, that the statutory foreign tax credit regime
implicitly displaces the economic substance doctrine; and second,
that a 1997 amendment to the foreign tax credit scheme, which added
what is now Internal Revenue Code § 901(k), implies that ADR
transactions that took place before the amendment are to be
recognized for tax purposes. Because we reverse the Tax Court’s
decision concerning the underlying transaction, it follows that the
court erred in imposing the negligence penalty and that the court’s
holding that Compaq was not entitled to deduct its out of pocket
losses becomes superfluous.
The decision of the Tax Court is REVERSED.
22