In the Penalty Box

A watershed ruling against Compaq Computer signals a decreasing tolerance for corporate tax shelters.
Russ BanhamJuly 1, 2000

It’s not news that the Internal Revenue Service doesn’t like tax shelters. But now the courts have given notice that seeking tax shelter may be more hazardous than braving the storm.

Such is the thrust of a controversial decision by the U.S. Tax Court in a case involving Compaq Computer Corp. Not only did former Chief Judge Mary Ann Cohen find Compaq had no “economic substance” behind an investment decision other than to obtain tax benefits, but the judge also took the highly unusual step of slapping the company with a penalty representing 20 percent of the taxes in question (roughly $500,000).

While Compaq is appealing the ruling, the case underscores the tax court’s growing hostility toward tax shelters–transactions undertaken primarily for tax avoidance rather than for business reasons. “There is a war on corporate tax shelters, and the front line is the tax court,” says Robert Willens, a managing director and tax and accounting analyst at New York­based investment bank Lehman Bros.

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“I’m not a great advocate for corporate tax shelters, and I’d be the first to tell you that some strategies coming out of the accounting firms are egregious,” he says. “Yet, by wielding solely the ‘economic substance’ doctrine as a basis for its decisions, the court may be overlooking other factors, including various statutory laws. The reality is that a company can lose virtually any case on the basis of economic substance alone. And that is a very disquieting thought.”

Dividend Stripping

Compaq’s tax problems started in 1992, when the company realized a capital gain of $231.7 million from the sale of stock in Conner Peripherals Inc. On hearing of Compaq’s gain, an investment firm specializing in arbitrage transactions, Twenty-First Securities Corp., sent the company a letter soliciting its business.

Twenty-First Securities suggested a number of arbitrage strategies to “take advantage” of the capital gain, its letter stated. One of them involved the purchase and sale of American Depository Receipts (ADRs) for shares of a foreign corporation, the customary way of trading foreign stocks on U.S. stock exchanges. And although Twenty-First Securities insists it was not advocating a so-called dividend-stripping approach–because it actually made about $2 million on the deal–others say the investment had all the characteristics of such strategies.

Typically, a company taking this route purchases a security “cum-dividend” (before the record date of the dividend), then immediately resells the same security “ex-dividend” (after the record date). The rationale is to buy stock in a corporation before the ex-dividend date, hold it for a period of time, and then sell the stock after the ex-dividend date. The hope is that the stock will decline by an amount roughly equal to the dividend, thereby replacing the capital gain on the sale of the stock with dividend income.

Why such odd machinations? Because the capital loss can offset a capital gain, pretty much wiping out the capital gain and replacing it with dividend income. “The trade-off can be worth it,” Willens explains. “Capital gains are taxed at full corporate rates, or 35 percent, while dividends received are taxed at 10.5 percent. Therefore, each dollar of capital gains you replace with dividends saves you 35 percent minus 10.5 percent, or 24.5 percent.”

With the help of Twenty-First Securities, Compaq placed an order at the New York Stock Exchange to purchase 10 million Royal Dutch Petroleum ADRs on September 16, 1992, trading with declared dividends payable to holders of record as of September 18, 1992.

The shares, purchased for roughly $888 million cum-dividend, involved special NYSE “next day” settlement terms, permitting Compaq to be the recordholder as of September 18 (the dividend payment date). Immediately following the purchase of the 10 million ADRs, they were sold back to the original broker with settlement terms of five days. Basically, Compaq bought the ADRs after the dividends had been declared, but before the record date for payment of the dividends. Thus, it was entitled to the dividends.

Royal Dutch Petroleum, according to court records, paid roughly $22.5 million in dividends to Compaq, on which about 15 percent, or $3.4 million in tax, was withheld and paid to the Dutch government. Compaq was paid the remainder, about $19.1 million. Compaq then claimed a foreign tax credit in the amount of the withheld tax on its 1992 U.S. federal income tax return, an amount offsetting part of the capital gain from the sale of stock in Conner Peripherals. Overall, the company reported a $22.5 million dividend, a $3.4 million foreign tax credit, and a $20.6 million short-term capital loss.

This much is not in dispute. However, the IRS, upon auditing Compaq’s tax return, determined the company was not entitled to the foreign tax credit. Why? Because the IRS felt the ADR transaction had no business purpose other than the reduction of taxes.

Robert Gordon, president of Twenty-First Securities, insists the deal was motivated by economic, not tax-relief, reasons. “We were trying to make money, not buy and sell a stock to obtain a tax-advantaged dividend,” Gordon says. In fact, although the ADR transaction lowered Compaq’s U.S. taxes because of the foreign withheld tax, the deal actually increased the company’s overall worldwide taxes, because the dividend paid was higher than the capital loss suffered, $22.5 million versus $20.6 million.

Judge Cohen rejected Gordon’s logic, however, arguing that the ADR transaction was “contrived” specifically to obtain U.S. tax relief. Her reasoning turns on the notion that a transaction must have economic substance–in other words, it must be “rationally related to a useful nontax purpose.” In strong rhetoric that took many in the tax profession by surprise, she stated that the ADR transaction had no purpose other than “to minimize taxes, [which] does not include the right to engage in financial fantasies with the expectation that the IRS and the courts will play along.”

Congressional Hedging

The U.S. Congress has ruled twice on “dividend stripping.” In 1984, Congress amended section 246(c) to require companies to sustain some market risk in a dividend-stripping scenario. “To earn the dividend-received deduction, Congress ruled that the stock has to be held for at least 46 days before it is sold. During that period, the exposures cannot be hedged except by call options,” Willens explains. “If you sold before the 46-day period or hedged the exposure with, say, a put option, you can’t get the tax credits.”

The ruling made dividend stripping unattractive–who would want to be exposed to the market for 46 days simply to obtain favorable tax credits? But Willens notes that Congress did not expressly rule against dividend stripping. “Congress basically said, ‘If you’re willing to bear market risk for this length of time, we have no problem with these strategies. We don’t think they’re inherently evil; we just want to impose conditions.’ At least, that’s what I think they were saying.”

In any event, traditional dividend stripping fell out of favor as a tax strategy. Meanwhile, smart investment advisers determined that the same concept could apply to foreign equities, for which section 246(c) would not apply. “Theoretically, there are no restrictions with respect to stripping a dividend from a foreign equity,” Willens says. “You don’t have to hold the stock for a minute, much less 46 days.”

With a foreign equity, the same scenario applies. A fully taxed capital gain is converted into a form of income that is much more tax-advantaged. The investment occurs cum-dividend, and the security is sold ex-dividend. But there’s a twist. The tax benefit flows from the foreign tax withheld, which is deducted from payable U.S. federal income taxes. The United States has signed treaties with many countries, including the Netherlands, to permit this deduction to avoid the specter of double taxation (paying taxes on a foreign equity to two countries).

In 1997, after some negative publicity about this loophole, Congress enacted section 901(k). The statute essentially applies the strictures imposed by section 246(c) to deals involving foreign equities. The only difference: Instead of a requirement to hold a stock for 46 days to obtain tax benefits, the time frame was reduced to 16 days.

Was Compaq Too Cavalier?

Flashback to Compaq: The IRS audits the company, the two parties cannot reach agreement administratively, and they square off in court. Obviously, the court cannot point to section 901(k) to justify a finding against Compaq, because the rule was not in place at the time. Gordon believes the court is applying current law under the guise of the economic-substance doctrine. “All we were doing is complying with the letter of the law that existed in 1992,” Gordon says.

“In 1997, the government changed the law to say that in order to get the benefit of a foreign tax credit on withheld dividends, you must hold the investment for 16 days unhedged. But there was nothing in the rules before then. It is unfair for the government to apply new law to old circumstances.”

Other tax experts note that the Compaq case was the first time the “economic substance” doctrine was wielded against a company declaring a foreign tax credit. “The U.S. has a treaty with the Netherlands that says if you pay the withholding tax, you get a foreign tax credit,” says Timothy McCormally, general counsel of the Washington, D.C.-based Tax Executives Institute. “Now it seems in order to obtain the foreign tax credit, you must also have an underlying business purpose guiding the foreign transaction.”

But Lee Sheppard, a New York­based lawyer, says that Congress never intended to permit a manipulation of the foreign tax credit to receive U.S. tax savings when no actual business was being conducted. “The economic-substance doctrine must still apply,” Sheppard says. Because it held the stock for only minutes, Compaq had insulated itself from risk. “The transaction was completely predictable,” Sheppard adds. “There was no risk or anything close to what we would call real investing.”

Had Compaq held the ADRs for a month, Sheppard says, “that would be risk. But an hour? Come on. Judge Cohen said as much in her ruling: ‘There was virtually no risk of price fluctuation. Transactions that involve no market risks are not economically substantial transactions. They are mere tax artifices.’ That’s it in a nutshell.”

Working against Compaq throughout the case was the company’s inability to produce evidence indicating that it approached the ADR transaction with the customary diligence accorded such large corporate investments. Court records, for example, indicate that Compaq assistant treasurer James J. Tempesta’s investigation of Twenty-First Securities and the ADR transaction was limited to telephoning a reference provided by Twenty-First Securities and reviewing a spreadsheet analysis of the transaction supplied by the firm. Tempesta shredded the spreadsheet a year after the transaction. The court’s apparent position: If Compaq were pursuing a money-making investment strategy that involved risk, why was it so cavalier?

McCormally’s colleague at the Tax Executives Institute, tax counsel Mary Lou Fahey, says the ruling “has given pause to legitimate businesspeople, who suddenly don’t know where the lines are drawn anymore. In effect, it second-guesses all business decisions. Courts in the past have affirmed that there is nothing wrong with trying to obtain the lowest tax, so long as it is the correct amount. Now it would appear any strategy deemed to lower taxes is suspect.”

Troubling Issues

The Compaq case also raises another unsettling issue: the tax court’s apparent rejection of congressional positions on dividend stripping. Twice Congress has ruled to allow dividend stripping within prescribed conditions. Says Marc Teitelbaum, a partner and head of the tax department at the New York­based law firm Sonnenschein Nath & Rosenthal, “Congress never referred to dividend stripping as sham transactions in the two reviews it conducted, yet the court apparently feels this way.”

In addition, Willens, McCormally, and Fahey say Judge Cohen may have overstepped her bounds in assessing a penalty. “For the court to impose a penalty seems absolutely unfair and improper,” says Willens. “Sure, Compaq could have done a better job cosmetically [in analyzing the investment], but that’s no basis for a penalty.”

Still, as Compaq prepares its appeal, the shadow already cast by the tax-court ruling is ominous. “We’re in an era where the use of quote-unquote corporate tax shelters is undergoing unbelievable scrutiny,” says Willens. Adds Sheppard, “If a guy comes to you with a tax shelter that sounds too good to be true, that’s because it is.”