Compaq Computer Corp. v. Comm'r of Internal Revenue, 24238–96.

• Decision Date: 21 September 1999
• Docket Number: No. 24238–96.,24238–96.
• Parties: COMPAQ COMPUTER CORPORATION, AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

113 T.C. 214

113 T.C. No. 17

COMPAQ COMPUTER CORPORATION, AND SUBSIDIARIES, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 24238–96.

United States Tax Court.

Sept. 21, 1999.

Mark A. Oates, John M. Peterson, Jr., James M. O'Brien, Owen P. Martikan, Paul E. Schick, Robert S. Walton, Tamara L. Frantzen, Erika S. Schechter, A. Duane Webber, David A. Waimon, Lafayette G. Harter III, and Steven M. Surdell, for petitioner.

Dennis M. Kelly, Ginny Y. Chung, and Rebecca I. Rosenberg, for respondent.

COHEN, Chief J.

In a prearranged transaction designed to eliminate typical market risks, P purchased and immediately resold American Depository Receipts (ADR's) of a foreign corporation on the floor of the NYSE. As a result of the transaction, P was the shareholder of record of 10 million ADR's on the dividend record date and received a dividend of $22,545,800 less withheld foreign taxes of $3,381,870, P also recognized a $20,652,816 capital loss on the sale of the ADR's, which was offset against previously realized capital gains. The net cash-flow from the transaction, without regard to tax consequences, was a $1,486,755 loss. Held: The transaction lacked economic substance, and the foreign tax credit claimed by P will be disallowed. Held further: An accuracy-related penalty will be imposed due to petitioner's negligence.

The issues addressed in this opinion are whether petitioner's purchase and reals of American Depository Receipts (ADR's) in 1992 lacked economic substance and whether petitioner is liable for an accuracy-related penalty pursuant to section 6662(a). (In a separate opinion, Compag Computer Corp. & Subs. v. Commissioner, T.C. Memo.1999–220, we held that income relating to printed circuit assemblies should not be reallocated under section 482 to petitioner from its Singapore subsidiary for its 1991 and 1992 fiscal years. Petitioner has also filed a Motion for Summary Judgment on the issue of whether petitioner is entitled to foreign tax credits for certain United Kingdom Advance Corporation Tax payments.) Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. Since 1982, petitioner has been engaged in the business of designing, manufacturing, and selling personal computers. Details concerning petitioner's business operations are set forth in T.C. Memo.1999–220 and are not repeated here.

Petitioner occasionally invested in the stock of other computer companies. In 1992, petitioner held stock in Conner Peripherals, Inc. (Conner Peripherals), a publicly traded, nonaffiliated computer company. Petitioner sold the Conner Peripherals stock in July 1992, recognizing a long-term capital gain of $231,682,881.

Twenty–First Securities Corporation (Twenty–First), an investment firm specializing in arbitrage transactions, learned of petitioner's long-term capital gain from the sale of Conner Peripherals, and on August 13, 1992, Steven F. Jacoby (Jacoby), a broker and account executive with Twenty–First, mailed a letter to petitioner soliciting petitioner's business. The letter stated that Twenty–First “has uncovered a number of strategies that take advantage of a capital gain”, including a Dividend Reinvestment Arbitrage Program (DRIP) and a “proprietary variation on the DRIP”, the ADR arbitrage transaction (ADR transaction).

An ADR (American Depository Receipt) is a trading unit issued by a trust, which represents ownership of stock in a foreign corporation that is deposited with the trust. ADR's are the customary form of trading foreign stocks on U.S. stock exchanges, including the New York Stock Exchange (N.Y.SE). The ADR transaction involves the purchase of ADR's “cum dividend”, followed by the immediate resale of the same ADR's “ex dividend”. “Cum dividend” refers to a purchase or sale of a share of stock or an ADR share with the purchaser entitled to a declared dividend (settlement taking place on or before the record date of the dividend). “Ex dividend” refers to the purchase or sale of stock or an ADR share without the entitlement to a declared dividend (settlement taking place after the record date).

James J. Tempesta (Tempesta) was an assistant treasurer in petitioner's treasury department in 1992. He received his undergraduate degree in philosophy and government from Georgetown University and his master's degree in finance and accounting from the University of Texas. Tempesta's responsibilities in petitioner's treasury department included the day-to-day investment of petitioner's cash reserves, including the evaluation of investment proposals from investment bankers and other institutions. He was also responsible for writing petitioner's investment policies that were in effect during September 1992. Petitioner's treasury department primarily focused on capital preservation, typically investing in overnight deposits, Eurodollars, commercial paper, and tax-exempt obligations.

On September 15, 1992, Tempesta and petitioner's treasurer, John M. Foster (Foster), met with Jacoby and Robert N. Gordon (Gordon), president of Twenty–First, to discuss the strategies proposed in the August 13, 1992, letter from Twenty–First. In a meeting that lasted approximately an hour, Jacoby and Gordon presented the DRIP strategy and the ADR transaction. Following the meeting, Tempesta and Foster discussed the transactions with Darryl White (White), petitioner's chief financial officer. They decided not to engage in the DRIP investment but chose to go forward with the ADR transaction, relying primarily on Tempesta's recommendation. Tempesta notified Twenty–First of this decision on September 16, 1992.

Although cash-flow was generally important to petitioner's investment decisions, Tempesta did not perform a cash-flow analysis before agreeing to take part in the ADR transaction. Rather, Tempesta's investigation of Twenty–First and the ADR transaction, in general, was limited to telephoning a reference provided by Twenty–First and reviewing a spreadsheet provided by Jacoby that analyzed the transaction. Tempesta shredded the spreadsheet a year after the transaction.

Joseph Leo (Leo) of Twenty–First was responsible for arranging the execution of the purchase and resale trades of ADR's for petitioner. Bear Stearns & Co., Inc. (Bear Stearns), was used as the clearing broker for petitioner's trade, and the securities selected for the transaction were ADR shares of Royal Dutch Petroleum Company (Royal Dutch). Royal Dutch ordinary capital shares were trading in 21 organized markets throughout the world in 1992, but primarily on the NYSE in the United States as ADR's. Before agreeing to enter into the transaction, petitioner had no specific knowledge of Royal Dutch, and Tempesta's research of Royal Dutch was limited to reading in the Wall Street Journal that Royal Dutch declared a dividend and to observing the various market prices of Royal Dutch ADR's.

In preparation for the trades, Leo determined the number of Royal Dutch ADR's to be included in each purchase and resale trade. He also selected the market prices to be paid, varying the prices in different trades so the blended price per share equaled the actual market price plus the net dividend. Leo did not, however, discuss the size of the trades or the prices selected for the trades with any employee or representative of petitioner. Leo also chose to purchase the Royal Dutch ADR's from Arthur J. Gallagher and Company (Gallagher). Gallagher had been a client of Twenty–First since 1985 and participated in various investment strategies developed by Twenty–First over the years. During 1991, Gallagher participated in several ADR transaction trades as the purchaser of the ADR's. Tempesta had no knowledge of the identity of the seller of ADR's. He only knew that the seller was a client of Twenty–First.

On September 16, 1992, Leo instructed ABD–N.Y., Inc. (ABD), to purchase 10 million Royal Dutch ADR's on petitioner's behalf from Gallagher on the floor of the NYSE. He also instructed ABD to resell the 10 million Royal Dutch ADR's to Gallagher immediately following the purchase trades. The purchase trades were made in 23 separate cross-trades of approximately 450,000 ADR's each with special “next day” settlement terms pursuant to NYSE rule 64. The aggregate purchase price was $887,577,129, cum dividend.

ABD executed the 23 sale trades, selling the Royal Dutch ADR's back to Gallagher, immediately following the related purchase trade. Accordingly, each purchase trade and its related sale trade were completed before commencing the next purchase trade. The sales transactions, however, had regular settlement terms of 5 days, and the aggregate sales price was $868,412,129, ex dividend. The 23 corresponding purchase and resale trades were completed in about an hour between approximately 2:58 p.m. and 4:00 p.m.

Leo had instructed the ABD floor brokers to execute the trades only if the prices selected were within the range of the current market prices. Thus, when, between the sixth and seventh trades, the market price changed, Leo modified the price for subsequent trades to compensate for the change. In addition, NYSE rule 76 required an open outcry for each cross-trade, and NYSE rule 72 allowed other traders on the floor or the “specialist” responsible for making the cross-trades to break up the transaction by taking all or part of the trade. However, for cross-trades priced at the market price, there was no incentive to break up the transaction.

Pursuant to the “next day” settlement rules, the purchase cross-trades were settled between petitioner and Gallagher on September 17, 1992. On that date, Gallagher's account with Bear Stearns was credited $887,547,543 for the purchase trades, including a...