Can the battle be won? Compaq, the sham transaction doctrine, and a critique of proposals to combat the corporate tax shelter dragon.
|Graber, Brion D.
At a time when our Congress seems reluctant to seek to slay, or even injure, the corporate tax shelter dragon, our courts, and particularly the Tax Court, are building the walls of the fortress from such time-tested concepts as form versus substance and economic substance and risk of loss, to protect the fisc from being overrun and trampled by such tax shelters.(1)
Recently, corporate tax shelters have become one of the biggest areas of concern in the United States's tax policy(2) The Department of the Treasury ("Treasury"),(3) Congressman Lloyd Doggett,(4) the Joint Committee on Taxation,(5) and the New York State Bar Association,(6) among others, have all made proposals on how to deal with this growing problem that deprives the federal treasury of over ten billion dollars per year.(7) Using the September 1999 Tax Court decision Compaq Computer Corp. v. Commissioners(8) as a framework, this Comment will examine the merits of these recent proposals, giving due consideration to traditional, primarily judicial, solutions.
Part I explains the facts of Compaq, focusing on the specific corporate tax shelter at issue in the case. The transaction, in essence, involved Compaq Computer Corp. ("Compaq") purchasing stock of a foreign corporation on which a dividend had been declared but not yet paid. After the dividend record date, Compaq sold the stock at a price equal to its original purchase price less the amount of the net dividend. Compaq was required to pay tax to a foreign country on the receipt of the dividend, and thus was able to claim a foreign tax credit. The opportunity to claim the tax credit was the goal of the entire transaction, and allowed Compaq to reduce its tax liability from unrelated transactions on a dollar per dollar basis.
Part II provides an analysis of the sham transaction doctrine that is crucial to understanding both the Compaq opinion and the merits of the proposed solutions to the corporate tax shelter problem. The courts have developed the sham transaction doctrine over the last sixty-five years to distinguish those transactions that should be recognized for tax purposes from those that should not, based primarily on whether the transaction possessed economic substance or a business purpose absent its tax effects. The analysis explains what factors the courts examine in making that determination.
With the background provided in Part II, Part III returns to Compaq to examine the Tax Court's opinion. The Tax Court relied heavily on the sham transaction doctrine in concluding that the transaction was an economic sham lacking both nontax economic substance and a nontax business purpose. The opinion also explains why an accuracy-related penalty was properly assessed against Compaq for its tax return reporting of the transaction.
Finally, Part IV examines several of the primary proposals to combat corporate tax shelters and identifies those that are constructive to pursue. Although not the principal focus of this Comment, special attention is given to discussing Treasury's temporary and proposed regulations because they are the most authoritative measure taken to date against corporate tax shelters.
This Comment asserts that requiring greater disclosure by corporations of potentially abusive transactions has the greatest capacity to curb corporate tax shelter abuse. Treasury is currently employing this strategy in the temporary and proposed regulations. Although the actual impact of the temporary and proposed regulations is not yet known, increased disclosure should allow the Commissioner of the Internal Revenue Service ("Commissioner") to expend his resources examining the merits of the disclosed transactions and disallowing those that are abusive, instead of aimlessly searching for potentially abusive transactions in the first place. Such a change should put an immediate end to many of the corporate tax shelters, which derive their value from the fact that they are unlikely ever to be discovered, rather than from any solid legal basis.
In addition, modifying the existing penalty structure would be beneficial, but only if done in conjunction with the new disclosure requirements. Modifications to the penalty system would provide additional incentives for taxpayers, whose compliance is voluntary, to act within the law. A similar benefit could be achieved by imposing an excise tax on the fees of corporate tax shelter promoters and advisors arising from nondisclosed corporate tax shelters.
Other proposals, such as codifying the existing judicial anti-tax-avoidance doctrines and providing consequences for tax-indifferent parties who participate in corporate tax shelters, however, are not beneficial and may actually exacerbate the corporate tax shelter problem by reopening closed loopholes or creating new ones. At its best, codification would simply repeat current, well established judicial doctrine. At its worst, codification would increase tax complexity and uncertainty for taxpayers and retard the ability of the Commissioner and the courts to enforce the tax laws. These proposals should not be pursued.
THE FACTS OF COMPAQ
Compaq's desire to minimize the tax liability resulting from a sizeable long-term capital gain on the July 1992 sale of stock it held in a publicly traded, nonaffiliated computer company provided the impetus for the transaction at issue in Compaq.(9) Shortly after the stock sale, Twenty-First Securities Corp. ("Twenty-First"), an investment firm, solicited Compaq's participation in a transaction designed to shield part of the long-term capital gain from tax.(10) During the first meeting on September 15, 1992, Twenty-First presented two suggested transactions to James J. Tempesta, an assistant treasurer at Compaq, and John M. Foster, Compaq's treasurer: a Dividend Reinvestment Arbitrage Program and an ADR arbitrage.(11) The day after the meeting, Compaq notified Twenty-First of its decision to pursue the ADR transaction.(12) Compaq made this decision based on a telephone conversation with a single Twenty-First reference and a review of a spreadsheet provided by Twenty-First, but without performing even a cash flow analysis of the transaction.(13)
Immediately upon learning of Compaq's decision, Twenty-First began to execute the ADR transaction.(14) The only guidance from Compaq during the transaction concerned the number of shares to purchase and the suggestion that the ADRs used should be those of Royal Dutch Petroleum Co. ("Royal Dutch").(15) Twenty-First decided from whom to purchase the ADRs, how large each trade should be, and "the market prices to be paid," but did not discuss these details with anyone from Compaq.(16)
Ultimately, Twenty-First ordered the purchase of ten million ADR shares of Royal Dutch on Compaq's behalf. The shares were purchased "cum dividend" and resold "ex dividend" in twenty-three separate cross trades that were completed in approximately one hour.(17) All ten million shares were purchased from a long-time client of Twenty-First, and then immediately resold to that same company.(18) The purchase cross trades were settled on September 17, pursuant to special "next day" settlement terms allowed by the New York Stock Exchange.(19) The resale cross trades were settled on September 21, pursuant to regular settlement rules.(20) Arranging the settlements in this way allowed Compaq to be the shareholder of record of the ADRs on the dividend record date, thereby entitling Compaq to receive the declared dividend.(21)
When Royal Dutch paid the dividend to its United States resident shareholders, including Compaq, it withheld and paid over to the appropriate taxing authorities of the Netherlands fifteen percent of the declared dividend, as required by law.(22)
Compaq reported a short-term capital loss ($20,652,816) from the purchase and resale of the ADRs on its 1992 federal income tax return.(23) Compaq also reported dividend income ($22,546,800) and, most importantly, claimed a foreign tax credit ($3,382,050) as a result of the transaction.(24)
TRADITIONAL SHAM TRANSACTION ANALYSIS
Americans have never found great fulfillment in paying taxes.(25) Consequently, they seek to minimize their tax liability by carefully structuring their personal and business dealings to take full advantage of the benefits available in the tax laws. The courts have recognized this fact and acknowledged the legality of such efforts for more than sixty years.(26) Judge Learned Hand commented on this principle:
Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.(27) That is not to imply, however, that everything that taxpayers do must be accepted by the Commissioner and the courts when applying the tax laws.(28) Over the years, several related judicial doctrines have arisen that limit taxpayers' ability to successfully engage in certain tax avoidance transactions. Principal among these is the sham transaction doctrine, which comprises both the economic substance and business purpose doctrines.
It is a well accepted principle that application of the tax laws depends on the substance of a transaction and not its form.(29) To look only at form would be to "exalt artifice above reality and to deprive the statutory provision in question of all serious purpose."(30) Furthermore, it would hinder the "effective administration of the tax policies of Congress."(31)
The Commissioner is therefore generally free to examine the substance of a transaction and then decide that either the transaction's form should be respected because it reflects its substance, or the form should be disregarded because it does not reflect the substance of the transaction.(32) A...
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