United States: U.S. Court Finds Foreign Tax Credit Strip Does Not Compute

Last Updated: December 14 2000
Article by Sanford H. Goldberg

In the recent Compaq case, a tax-shelter promoter persuaded the taxpayer to engage in a no-economic-profit transaction for foreign tax credits on ADRs. Without proof that the economics were evaluated and absent a legal opinion, the US Tax Court disregarded the transaction and imposed a negligence penalty.

In the recent Compaq Computer Corp. case1, the US Tax Court applied the rejuvenated "business purpose" doctrine and rejected a corporation's attempt to strip off dividends to garner foreign tax credits. Under the business purpose doctrine, tax-motivated transactions entered into without any expectation of economic gain can be disregarded as shams. This principle was at the heart of an earlier decision by the Tax Court, ACM Partnership2 that struck down a tax-shelter transaction on the basis of the contingent installment sale rules. Practitioners can expect to see the Court brandish this doctrine with more frequency in the present war being waged by the Internal Revenue Service (the "Service") against alleged corporate tax shelters.


As in ACM, the Compaq case involved cross-border transactions. In Compaq, the taxpayer realized a large capital gain in 1992 from the sale of a block of stock in another computer company. Compaq was approached that year by an investment firm promoting tax-arbitrage transactions. The taxpayer ultimately decided to pursue one of those strategies, known as "ADR arbitrage" transactions.

An ADR (American depository receipt) is a trading unit, issued by a trust, that represents ownership of stock in a foreign corporation that is deposited with the trust. ADRs are the customary form of trading foreign stocks on US stock exchanges. By published ruling, the Service generally has treated ADRs as stock in the underlying company. ADR arbitrage transactions involve the purchase of ADRs "cum-dividend," followed by the resale of the same ADRs "ex-dividend." An ADR cum-dividend provides the purchaser with the right to receive a declared dividend (settlement taking place on or before the record date of the dividend). An ADR ex-dividend refers to the ADR after the declared dividend is considered paid (settlement taking place after the record date).

The promoter in Compaq arranged for one of its financial customers that owned a large number of Royal Dutch Petroleum ADRs (the "ADR owner") to enter into two sets of transactions with the taxpayer. The promoter arranged for the ADR owner to sell ADRs representing 10 million shares of Royal Dutch to the taxpayer at prevailing market prices, and for the taxpayer to resell the shares to the ADR owner at a predetermined price. The purchases and resale transactions occurred on the same date, September 16, 1992. The purchase trades were executed with special "next-day" settlement terms, whereas the resale trade was subject to ordinary settlement terms, or after five days. As a result, the taxpayer was the record holder of the shares on the date of record for the Royal Dutch dividend. Royal Dutch, a Netherlands corporation, had declared its dividend payable to its shareholders of record on September 18, 1992. The purchase was executed through 23 separate trades, each of which was immediately followed by a corresponding sale, and all of which were completed within a period of about one hour.

On September 18, 1992, Royal Dutch paid dividends of $22,545,800 on the subject shares and withheld tax equal to 15%, or $3,381,870, with respect to the shares underlying the subject ADRs. The taxpayer reported the gross amount of the dividends as ordinary income, and claimed a foreign tax credit for the withheld tax. As a result of the spread between the purchase price of the ADRs ($887,577,129) and the sale price ($868,412,129 plus additional transaction costs of about $1.4 million), the taxpayer also reported a capital loss of $20,652,816. The taxpayer claimed the loss in 1992 as an offset to the capital gain it had recognized on the unrelated sale of stock, so the transaction resulted in a net increase in taxable income of only $1.9 million to Compaq. The overall effect of the transactions, as reported, was a net tax savings of $2.7 million (foreign tax credits of $3.4 million minus 35% tax on $1.9 million of net income). From a pure cash flow perspective, the transaction cost the taxpayer about $1.4 million, as illustrated by the following analysis, taken from the opinion:

Cash-flow from ADR transaction:

ADR purchases


ADR sales


Net cash from ADR transactions

($ 19,165,000)

Cash-flow from dividends:

Gross dividends


Netherlands withholding tax


Net cash from dividends




Transaction costs:



Less: Adjustment


SEC fees


Margin writeoff




Net transaction costs





The US Tax Court concluded that the ADR transactions lacked economic substance. The taxpayer had argued that the ADR transaction should not be viewed as lacking a pre-tax profit motive, since it actually recognized a net gain of $1.9 million on the transaction ($22,545,800 - $19,165,000 - $1,485,685 = $1,895,115). The Court responded to this argument by noting that the Netherlands withholding tax of $3.3 million represented a real economic cost that must be taken into account in measuring the profit potential under the business purpose test. This conclusion, at the heart of the Court's reasoning, may have obviated a better means of attacking the ADR arbitrage transaction, as discussed further below. This issue will also likely become important in future cases.3

On the basis of its reasoning, the court perhaps should have accepted the taxpayer's alternative argument -- namely, that the transaction could not have been tax motivated, because it actually increased the taxpayer's overall tax burden. In support of this argument, the taxpayer noted that each dollar of US tax savings arising from the ADR transaction represented an additional dollar of actual tax that was paid to a foreign government. The Court did not directly respond to this argument; instead, it focused on whether the taxpayer had a pre-tax profit motive.

One answer to the taxpayer's alternative argument is that the taxpayer did not really bear the economic cost of the Netherlands' withholding tax. This becomes apparent when the taxpayer's capital loss is compared with the amount of the dividend. In Compaq, the difference between the price at which the ADRs were purchased, cum-dividend ($887,577,129), and the price at which they were immediately thereafter resold, ex-dividend ($868,412,129), was $19,165,000. This amount was exactly the same as the dividend, net of Netherlands' withholding tax.4 Thus, the taxpayer effectively purchased the dividend net of the withholding tax, paying over $1 million for the privilege. The ADRs were repurchased by the original owner at a predetermined price equal to the original sales price less the net dividend; the extra costs were transaction costs and additional US taxes. The court probably avoided taking this approach to answering the taxpayer's alternative argument because it appeared inconsistent with the notion that foreign withholding taxes represent a real economic cost, which, as noted above, was what the Court concluded.

One approach that seems to avoid this apparent logical difficulty is to embrace the conclusion that the taxpayer did not bear the economic cost of the withholding tax, and to focus instead on the fact that the net taxable income resulting from the transaction did not represent a real economic profit, since it arose solely from the phantom $3.3 million portion of the dividend that never really belonged to the taxpayer.

Indeed, the Court could have reached the same result by applying the step transaction doctrine, given that there were binding agreements preventing the taxpayer from having benefits or detriments from the transaction, or by applying the substance-over-form (or sham) analysis that the taxpayer never really had the benefit and burden of ownership of the ADRs. If the Court had taken either of these two approaches, it appears that the taxpayer would have had no net taxable income from the transaction.5 Further proceedings may be necessary to determine whether the net economic loss was deductible to the taxpayer. Apparently, any appeal from this case may await resolution of this and certain other matters of the taxpayer pending in the top court.

This case will not shut down ADR transaction strategies entirely, as long as there is no fixed-price repurchase arrangement in place when ADRs are acquired, and as long a the taxpayer holds the stock for sufficient time to satisfy new section 901(k).6 That provision, enacted in 1997, requires that a taxpayer hold stock (or ADRs) for at least 15 days immediately preceding or following the dividend record date in order to be eligible for a foreign tax credit with respect to withholding taxes imposed on stock dividends.

The taxpayer in Compaq argued that the enactment of Section 901(k) implied that Congress did not believe that pre-effective-date transactions would forfeit the foreign tax credit.7 The Court rejected this argument, relying in part on language in the legislative history, which stated that Congress made no inference with respect to tax- motivated transactions designed to transfer foreign tax credits which were entered into before the effective date of the new law. Similar language appears in the legislative history of many new tax provisions. Practitioners may generally have assumed that such language means that no negative inference was to apply to prior transactions, but the Court in Compaq simply stated that "a transaction does not avoid economic scrutiny because the transaction predates a statute targeting the specific abuse."8

The Court also upheld the imposition of a negligence penalty on the company, pointing to two specific factors. One was the taxpayer's failure to prove that it performed any economic analysis of the transaction (one spreadsheet on the transaction had been shredded). The other factor was the taxpayer's failure to rely on the specific advice of tax counsel or its tax department as to the validity and soundness of its position.


Taxpayers who engage in transactions with apparently favorable tax consequences should bear in mind the role of economic analysis, and the necessity of both sufficient pre-tax economic profit potential and a tax opinion in order to defend against penalties.

Compaq represents yet another small but potentially meaningful victory for the Service. The case seems significant, even if possibly misguided, in its application of the business purpose doctrine. Ironically, cases like Compaq suggest that the Service and the courts are well enough equipped to defend aggressive corporate tax shelters without any new and expansive legislation.


1. 113 T.C. No. 17, (1999).

2. 73 TCM 2189 (1997), aff'd. 157 F.3d 231 (3d Cir. 1998).

3. Note that the presidential fiscal year 2000 budget proposal contains several proposals concerning US corporate tax shelters; one provision would treat foreign taxes as an economic cost. See United States Congress, Joint Committee on Taxation, Description of Revenue Proposals Contained in the President's Fiscal Year 2000 Budget Proposal, JCS-1-99 (Washington, DC: US Government Printing Office, 1999).

4. The net dividend was actually $19,163,930, but the $1,070 discrepancy resulted from an error by the broker, which adjusted its commission to offset this mistake.

5. But see IES Industries, Inc. v. U.S., docket no. C97-206, September 22, 1999 (ND Iowa), disallowing a deduction not only for foreign taxes paid in an ADR transaction but also for transaction costs.

6. Internal Revenue Code of 1986, as amended.

7. But see IRS Notice 98-5, 1998-3 IRB 49.

8. Supra footnote 1, at 4175.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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