Compaq Computer Corporation and Subsidiaries v. Commissioner of Internal Revenue

Compaq Computer Corporation (Compaq) (plaintiff) was a domestic entity designing, manufacturing, and selling personal computers. Compaq sometimes purchased the stock of other computer companies, and in 1992, Compaq sold stock in Connor Peripherals, which caused a long-term capital gain of $231,682,881. Compaq then invested with Twenty-First Securities Corporation (Twenty-First) in response to a letter soliciting Compaq’s business that hyped an American Depository Receipt (ADR) transaction. An ADR was a trading unit issued by a trust, representing stock ownership in a foreign corporation. With the help of multiple meetings, Compaq moved forward with an ADR strategy. Joseph Leo (Leo) of Twenty-First eventually bought 10 million Royal Dutch ADRs for Compaq for over $887 million and almost immediately sold the ADRs for over $868 million. Twenty-First collected nearly $1 million in commissions. Due to a five-day settlement period, Compaq was entitled to a dividend of $22.5 million from Royal Dutch, which was paid, with a corresponding payment made to the Netherlands government for withholding amounts. Compaq then reported a capital loss of just over $20 million from the ADR, with dividend income of $22.5 million and a foreign tax credit of $3.382 million withheld and paid to the Netherlands government. The Commissioner of Internal Revenue (the commissioner) (defendant) argued that the entire ADR transaction was deliberately designed to yield a specific result, with no reasonable possibility of a profit from the transaction without anticipated tax consequences. Compaq argued that it actually turned a profit of $1.8 million on the deal, as the Royal Dutch dividend exceeded the capital gains loss and transaction costs by that amount. The government argued that Compaq had a loss of $1.4 million. The government also argued against giving Compaq any tax benefits, as the entire ADR situation had no purpose aside from obtaining a foreign tax credit benefit and offsetting the capital gains noted above. The commissioner further attempted to impose a penalty for underpayment of tax based on negligence in underestimating the tax.