FTC denied in Compaq due to lack of business purpose.
An ADR is a trading unit issued by a trust, which represents stock ownership in a foreign corporation. Compaq purchased and immediately resold a large quantity of ADR shares of Royal Dutch Petroleum Company over a dividend record date. Although the sales of the ADRs had regular settlement terms of five days, the purchases were subject to "next day" settlement, so that Compaq was the shareholder of record on the dividend record date. The purchases and sales of the ADRs took place over a 62-minute period. To further minimize risk, the purchases and sales were broken down into 23 trades; the sale of the first trade was completed before the second trade was purchased. The dividend on the ADRs was subject to a 15% Netherlands withholding tax. Compaq reported the dividend income and claimed a capital loss from the sale of the ADRs and an FTC for the withholding tax. Treating the Netherlands withholding tax as a cost, Compaq suffered a $1.5 million loss on the transactions.
The Tax Court denied the $3 million FTC that Compaq claimed, because the ADR transactions had no business purpose and no economic substance. The court found that Compaq "had no reasonable possibility of a profit from the transactions" Compaq had argued that it had a "pre-tax" profit of $1.9 million, not taking into account U.S. income taxes and Netherlands withholding taxes. The court rejected Compaq's computation of profit, treated the withholding taxes as a cost and found that the transactions locked Compaq into a substantial pretax (i.e., pre-U.S. tax) loss. Echoing (though not citing) Notice 98-5, the court concluded:
The foreign tax credit serves to prevent double taxation and to facilitate international business transactions. No bona fide business is implicated here, and we are not persuaded that Congress intended to encourage or permit a transaction such as the ADR transaction, which is merely a manipulation of the foreign tax credit, to achieve U.S. tax savings.
The court further held that, because Compaq "failed to take even the most rudimentary steps to investigate the bona fide economic aspects of the ADR transaction" the IRS was also justified in imposing Sec. 6662(a) accuracy-related negligence penalties with respect to the FTC claimed.
Since Congress shut down "ADR dump" transactions in 1997 through the enactment of Sec. 901(k) (which imposes a holding period requirement for FTCs on dividends), the principal significance of the opinion lies in its potential effect on the Notice 98-5 regulations and the development of the sham transaction doctrine for FTCs. As to Notice 98-5, the Compaq opinion buttresses the IRS's position in two respects:
1. The opinion arguably supports the Service's authority to issue Notice 98-5 regulations. The notice claims that the congressional intent behind the FTC was to facilitate business transactions, not "tax-motivated" transactions--the Compaq opinion makes the same argument.
2. The opinion adopts the view of Notice 98-5 that, in applying a profit test, foreign taxes are treated as costs. "Pre-tax" profit is computed by subtracting foreign taxes, but not U.S. income taxes.
Very possibly, the Compaq opinion will encourage the government to take a hard line in Notice 98-5 regulations (which are on the IRS's Business Plan this year). Arguably, some of the transactions "blessed" in the Service's agreement with the Securities Industry Association (SIA) would be caught by the Tax Court's analysis in Compaq, but the IRS is not expected to abrogate that agreement. (In an exchange of letters with the SIA, the Service agreed not to apply the profit test to certain securities dealer transactions, "unhedged spread loans" including "related party lending transactions" and certain "market making activities") It also can be expected that the IRS will use Compaq to attack egregious Notice 98-5-type transactions occurring prior to the notice's effective date.
Note: In an unpublished opinion released the day after the Compaq opinion was issued, an Iowa district court granted the Service summary judgment in another buy-sell ADR case (IES Industries, Inc., DC Iowa 1999). The court held that the ADR transactions were shams and had to be disregarded for income tax purposes. The court denied a deduction for an $84 million capital loss recognized on the sale of the ADRs. In a year not before the court and closed for assessment, the IRS had permitted interest expense, commissions and 50% of the withholding taxes on the ADRs to be claimed as deductions. Under the equitable recoupment doctrine, the court permitted the Service to recoup the tax reduction resulting from these deductions as an offer against overpayments made by the taxpayer. (Interestingly, the court did not discuss whether the dividends from the ADR transactions should also be disregarded for tax purposes.)
FROM PEG O'CONNOR, WASHINGTON, DC
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|Title Annotation:||foreign tax credit|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2000|
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