Compaq redux: implicit taxes and the question of pre-tax profit.

I. INTRODUCTION

Until recently, (1) more ink was probably spilled over the cross-border, dividend-stripping transactions in Compaq v. Commissioner (2) and IES Industries v. Commissioner (3) than over any other tax shelter litigation. (4) In both cases, the appellate courts reversed the trial courts' decisions in favor of the government, thereby granting the taxpayers the tax benefits they sought.

One reason why those cases have received and continue to receive so much attention is because the commentators are divided into two opposing camps. One group argues that the transactions were blatant, abusive tax shelters that the courts should have struck down. The other group argues that the transactions were economically profitable arbitrage transactions that deserved respect from the courts.

The debate is so vigorous because neither side has been able to come to grips with the other side's strongest argument. In spite of their best efforts to show otherwise, (5) the defenders of the circuit courts' opinions have not been able to demonstrate a convincing economic justification for the transactions other than tax reduction. (6) Similarly, critics of those opinions have not been able to rebut the claim that the transactions generate pre-tax profits. (7)

The debate, thus, strikes at the heart of anti-abuse jurisprudence, which for many years has relied heavily on the concept of pre-tax profit. (8) Over the years, courts have developed a series of doctrines that supplement statutory and administrative authorities. One of those doctrines is the economic substance doctrine.

In the conjunctive form in which it is usually stated, the economic substance doctrine requires both that the transaction has non-tax consequences and that the taxpayer has a non-tax motive. Although the pre-tax profit test plays a role in both prongs of the economic substance doctrine, it is frequently the centerpiece of the objective prong. A financial transaction that has a guaranteed pre-tax profit (appropriately measured) improves the taxpayer's economic situation and so it has a positive non-tax consequence. Conversely, a financial transaction that has a guaranteed pre-tax loss worsens the taxpayer's economic situation. If such a transaction produces a substantial tax benefit (and if the taxpayer entered into it with knowledge of that result), then the taxpayer must have only a tax motive. (9) Thus, in the context of financial arbitrage transactions, courts use the pre-tax profit test in order to separate economic arbitrages (the tax consequences of which are respected) from tax arbitrages (the tax consequences of which are not respected). (10)

The rationale for and the logic behind the pre-tax profit test is that any system as complicated and extensive as the U.S. tax law will contain numerous inconsistencies. When these inconsistencies are aggressively exploited, they allow taxpayers to reduce their taxes with very little consequence to the risk they bear, their cash flows, or their economic interests. The availability of such tax shelters, according to this line of reasoning, is outside the scope of congressional intent. Accordingly, courts will strike down transactions that fail the pre-tax profit test. (11)

With this history as background and precedent, the taxpayers and the commentators who sided with them argued that the transactions in Compaq and IES Industries should be respected and the taxpayers' claimed tax benefits allowed. They emphasized the point that the parties, at the time they entered into the transactions, had a reasonable expectation (and possibly a guarantee) of a before-tax profit from the transactions. The Fifth and Eighth Circuit Courts of Appeal agreed. Conversely, the government and the commentators who sided with them argued that the transactions were abusive tax shelters. In their view, the transactions--even though they yielded pre-tax profits--were nothing more than sales of U.S. foreign tax credits to domestic companies. (12) The trial courts agreed.

Compaq and IES Industries thus threaten to confuse tax shelter jurisprudence (even more deeply than it already is). The transactions appear to be tax shelters because they lack a nontax justification. At the same time, they pass the pre-tax profit test. Accordingly, several commentators argue that the pre-tax profit test needs to be abandoned or modified to reach such transactions. The problem and cause for concern is that it is not clear what test will replace the pretax profit test if that test is discarded. Some commentators favor a standard for abusive tax shelters along the lines of "we know it when we see it." (13) Many tax practitioners and commentators might be fine with using such a broad and indeterminate standard if the final decisions are to be made by the Tax Court. (14) Fewer would be prepared to grant such broad discretion to generalist courts, whether as trial courts or when reviewing the Tax Court. (15) Fortunately, Congress was able to avoid pushing the courts to discard the pre-tax profit test, at least for now, with a statutory fix that addressed the specific transaction at issue. (16) However, such a fix only eliminated the immediate problem raised by cross-border, dividend-stripping transactions. A similar problem might arise in the future with other cross-border, stripping transactions. (17) Furthermore, if Compaq and IES Industries reveal the existence of a fissure in anti-abuse jurisprudence, Congress's statutory fix does not close it, but merely masks it.

A deeper and more detailed resolution of the fundamental issue in Compaq and IES Industries is therefore warranted. Such an exercise is not only of historical significance: the issues raised by Compaq and IES industries are still before the federal courts. The federal government having lost Compaq in the Fifth Circuit and IES Industries in the Eighth Circuit is pursuing similar cases in other circuits. (18) Also, the cross-border, dividend-stripping transactions in Compaq and IES Industries are not the only cross-border, stripping transactions that give rise to foreign tax credits. How to handle such transactions is an important issue and is likely to remain so for some time. In addition, a broader resolution of the issues raised in Compaq and IES Industries might tell us something about our tax system that we have overlooked.

II. THE TRANSACTIONS

The transactions in Compaq and IES Industries are very similar. I will use the Compaq transaction to illustrate. The numbers are approximate and have been rounded for ease of discussion. On September 16, 1992, Compaq purchased and later that same day sold 10 million shares of Royal Dutch Shell. (19) The trades, which were made using American Depository Receipts (ADRs), were executed on the New York Stock Exchange (NYSE). (20) Compaq paid $887.5 million for the Shell ADRs and sold them for $868.4 million. Although Compaq held the shares for only about one hour, the transactions were timed so that Compaq would be the owner of record for Shell's October 1992 dividend. On October 2, 1992, Shell declared a dividend of $2.25 a share. Thus, Compaq was entitled to receive a $22.5 million dividend from Shell (the gross dividend).

Because Shell is a Dutch company, all dividends paid by Shell to its shareholders are Dutch source income. Under the terms of the tax treaty between the United States and the Netherlands, the Netherlands imposed a 15 percent withholding tax on dividends received by U.S. residents from Dutch companies. Thus, Compaq incurred $3.4 million in Dutch taxes on the $22.5 million dividend. (21) The Dutch tax was remitted by Shell before the dividend was paid to Compaq. The payment, however, was on behalf of Compaq and discharged its tax obligation. Accordingly, after remitting the Dutch withholding tax, Shell paid Compaq $19.1 million (the net dividend).

As a U.S. company, Compaq is taxable in the United States on its worldwide income from all sources. (22) Thus, Compaq reported the $22.5 million gross dividend from Shell as gross income on its 1992 U.S. tax return. (23) Because Compaq was subject to tax at the top U.S. corporate tax rate of 34 percent, (24) that income attracted $7.7 million of tax. (25) In addition, Compaq reported a short-term capital loss of $20.5 million from its sale of Shell stock. (26) Because Compaq had other capital gains that it offset with that loss, the Shell loss reduced Compaq's U.S. federal income taxes by $7 million. (27) Thus, the Shell transaction increased Compaq's U.S. tax obligation by $0.7 million the difference between $7.7 million and $7 million. (28)

Furthermore, the United States permits Compaq to receive a tax credit for withholding taxes paid to the Netherlands. (29) Accordingly, Compaq claimed a U.S. foreign tax credit for the $3.4 million in foreign withholding taxes paid to the Netherlands on its Shell dividend.

The above transaction, however, was not costless. Compaq incurred expenses of roughly $400,000 and paid Twenty-First Securities, the promoter, a fee of $1 million. (30)

Assembling all of the pieces of the transaction, Compaq's proceeds from the sale of the stock and the dividend total $890.2 million. Its cost of purchasing the stock was $888.9 million. The difference--$1.3 million--is Compaq's net after-tax profit from the transaction.