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Corporations Cry, "Gimme Shelter"
Tim Francis-Wright

A recent decision by an appellate court allowed Compaq to use a disputed $3.4 million tax credit on its 1992 tax bill. Normally, that decision would not be worthy of notice, especially since the loophole used by Compaq expired in 1997. But the reasoning in the opinion attacks the very rationale that the IRS uses against dodgy tax shelters of all kinds. Unless Congress supports the IRS with amendments to the Internal Revenue Code, then taxation of large corporations might be a theoretical notion only.

In September 1992, Compaq Corporation paid Twenty-First Securities $1,000,000 to orchestrate some tax savings. Royal Dutch Shell, a Dutch company, was about to pay a dividend that was subject to a Dutch withholding tax of 15 percent. In the span of 62 minutes on 16 September, Compaq bought 10,000,000 American Depository Receipts (ADRs) of Shell on the New York Stock Exchange. Immediately after each purchase of about 450,000 ADRs, Compaq sold the shares back to the original seller, at an aggregate loss of $19,165,000, or 85 percent of the declared dividend on the shares. Special rules of the New York Stock Exchange allowed Compaq to be the stockholder of record through 18 September, the record date of the dividend.

Compaq planned to come out ahead on the transaction by claiming a capital loss of $20,650,000 (the $19,165,000 capital loss, plus $1,000,000 to the promoter and $485,685 in interest and trading costs), but a foreign tax credit equal to the tax withheld by the Dutch government of almost $3,400,000. The original seller entered the transaction with Compaq because it could not use the foreign tax credit—either it was an exempt organization like a pension fund, or its tax liability was already zero and the foreign tax credit was therefore useless.

The Tax Court ruled that the transactions lacked economic substance. Without the foreign tax credit, Compaq had no hope of showing a profit on the transaction after the necessary Dutch withholding tax. Its trades in the Shell ADRs were specifically arranged to generate an exact amount of loss. They were not subject to anything approaching the level of scrutiny that Compaq applied to the investments that it made in the normal course of business.

The Fifth Circuit Court of Appeals recently reversed the decision of the Tax Court. It ruled that the trades did have economic substance because Compaq made a profit before imposition of the mandatory Dutch withholding taxes. That Compaq was always unable to avoid the Dutch taxes appears not to have concerned the appellate judges. The IRS tried to use the anti-abuse rules in the Internal Revenue Code to stop Compaq, but the Court of Appeals used the vagueness of the economic substance doctrine against the IRS, its promoter.

The appellate court decision does not have a direct impact on any games that corporations might play today with the foreign tax credit. The website of the promoter of the tax shelter does not even mention the foreign tax credit. In 1997, Congress and the Clinton administration enacted subsection 901(k) of the Internal Revenue Code to force taxpayers to hold stock for at least 15 days to claim a foreign tax credit.

The real impact of the decision is that it weakens an effort by the IRS to force tax shelters to have economic substance independent of their tax savings. The judiciary has long ruled, and the IRS long acknowledged, that taxpayers can legally organize their affairs to pay as few taxes as possible. Indeed, many of the tax credits and tax preferences in the Internal Revenue Code are there precisely to encourage taxpayers to engage in certain activities. In this case, the foreign tax credit encourages international investment by preventing double taxation of foreign income. But the actions must have some economic rationale even before the imposition of federal taxes.

A favorite tax shelter for multinational corporations involves leases of equipment and other property between affiliates in different nations. Sometimes, these cross-border leases ultimately involve shifting the ultimate responsibility for taxes onto some foreign governmental entity. The main argument for the IRS against such schemes is to show that these transactions would not exist but for the tax benefits they produce. If the appellate courts are set to expand the definition of economic substance to fit cases such as that of Compaq's "investment" in Shell ADRs, then it is open season for corporate tax departments. In theory, multinational corporations might be able to concoct tax shelters so powerful that paying federal taxes might be entirely optional.

Congress has avoided putting the economic substance doctrine into the Internal Revenue Code. In its place, as it did in 1997 regarding the foreign tax credit, it has made piecemeal amendments to cover specific abuses. As a consequence of its inaction, Congress risks having more corporations like Compaq make deals that abuse the provisions of the tax code.

(Disclaimer: My day job involves the use of two federal tax credits. It primarily involves the federal low-income housing tax credit, which has a specific exemption from the economic substance doctrine. It sometimes involves the federal historic rehabilitation tax credit, which does not have such an exemption. Both credits have strict rules that effectively prevent corporations from claiming them without putting capital at risk for substantial periods of time: 15 years and 5 years, respectively. On its face, the appellate ruling eases the burden somewhat for investors in historic rehabilitation credit investments. But it also endangers the low-income housing credit industry by showing corporations riskless ways to pay less in taxes.)

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