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. At trial, the Commissioner of Internal Revenue (the commissioner) (defendant) argued that the entire ADR transaction lacked economic substance and had no valid business purpose. The tax court ruled for the commissioner, and Compaq appealed. Compaq argued the business purpose of its transaction—that the gained foreign tax credit and the dividend profits held actual value—and the economic substance. Although Compaq contested that it turned a profit of $1.8 million, the commissioner and the trial court disregarded the tax credit in assessing profitability and argued that the transaction was designed as a loss.