Compaq Computer Corp. v. Commissioner of Internal Revenue, No. 00-60648

• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)
• Writing for the Court: Before JONES, SMITH, and DeMOSS; EDITH H. JONES
• Citation: 277 F.3d 778
• Docket Number: No. 00-60648
• Decision Date: 28 December 2001
• Parties: (5th Cir. 2001) COMPAQ COMPUTER CORPORATION AND SUBSIDIARIES, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee

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277 F.3d 778 (5th Cir. 2001) COMPAQ COMPUTER CORPORATION AND SUBSIDIARIES, Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. No. 00-60648 UNITED STATES COURT OF APPEALS
FIFTH CIRCUIT December 28, 2001

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Appeal from the Decision of the United States Tax Court

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 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

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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 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 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

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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 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.

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 (10th Cir. 1990). Because we conclude that the ADR transaction in this case had both

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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...