## Facts

- The IRS asserted deficiencies and an accuracy-related negligence penalty for Compaq’s 1992 tax year based on a short-term “dividend-capture” arbitrage transaction involving American Depositary Receipts (ADRs) of Royal Dutch Petroleum.
- Compaq learned of the transaction from Twenty-First Securities Corporation, an arbitrage-focused investment firm, and decided to proceed after internal discussions among treasury and finance executives.
- Compaq performed limited independent diligence, relying largely on Twenty-First’s spreadsheet and a reference check; Twenty-First selected the trade size, pricing, and the counterparty.
- On September 16, 1992, through Twenty-First, Compaq bought 10 million Royal Dutch ADRs “cum dividend” (entitled to a declared dividend) and promptly resold them “ex dividend” (no longer entitled to the dividend).
- The dividend was subject to Dutch withholding tax; the overall transaction produced a small pre-tax profit from trading but generated substantial U.S. tax attributes (foreign tax credits for the withholding tax and capital losses tied to the dividend-related price movement).
- The Tax Court held the transaction lacked economic substance and disregarded it for federal income tax purposes, disallowing the credits and losses and sustaining the related determinations against Compaq.

## Issues

1. Whether Compaq’s ADR dividend-capture transaction lacked economic substance and should be disregarded for federal income tax purposes.
2. If the transaction is respected, whether Compaq may claim foreign tax credits for Dutch withholding tax on the dividend and recognize the associated capital losses.
3. Whether Compaq is liable for an accuracy-related penalty for negligence under I.R.C. § 6662.

## Decision

- The Fifth Circuit reversed the Tax Court.
- The court held, as a matter of law, that the ADR transaction had economic substance and a business purpose and therefore could not be disregarded.
- The court held Compaq was entitled to the foreign tax credits and the loss recognition generated by the transaction.
- Because the deficiency determinations were reversed, the associated negligence penalty could not stand.

## Legal Principles

- A transaction is not a sham for tax purposes when it involves real market trades, exposure to genuine market risk, and a realistic opportunity for pre-tax profit, even if the expected profit is small relative to anticipated tax benefits.
- In evaluating pre-tax profit for economic-substance purposes, foreign withholding taxes connected to a real dividend may be treated as tax consequences of the transaction rather than as an adjustment that negates objective profitability.
- A taxpayer’s tax motivation, standing alone, does not justify disregarding an otherwise real transaction that produces actual income and actual tax payments within the Internal Revenue Code’s framework.
- Where statutory requirements for the foreign tax credit are met through real dividend payments and actual foreign withholding, courts should not deny credits by recharacterizing the transaction absent a lack of economic reality.

## Conclusion

The Fifth Circuit held that Compaq’s ADR dividend-capture arbitrage involved real purchases and sales with market risk and pre-tax profit potential, so the transaction had economic substance and was respected for tax purposes, allowing the foreign tax credits and related losses and eliminating the basis for the negligence penalty.


Compaq Comput. Corp. & Subsidiaries v. Comm’r of Internal Revenue, 277 F.3d 778 (5th Cir. 2001)