What constitutes a “sham transaction” for tax
purposes? U.S. case law has evolved to incorporate business purpose
and economic substance as critical elements in determining what
constitutes a sham. Under the subjective business purpose test, the
court attempts to measure the taxpayer’s intent. Traditionally, it has
done this by examining the extent to which a taxpayer has investigated
the transaction and its consequences. Under the objective economic
substance test, the court tries to measure a transaction’s profit
potential apart from tax benefits.
IES Industries, an electric utility, purchased American Depository Receipts (ADRs) at market price plus 85% of the expected gross dividend (net of the 15% foreign withholding tax). For example, if the purchase price for a stock was $500 and there was to be a $100 dividend, IES would buy the stock for $585. After the dividend was paid, IES would sell the stock at a “loss” for its $500 market value. While IES was generating capital losses on each ADR purchase and sale (losses it carried back to offset capital gains in 1989 and 1990), overall the company made a profit because the dividends it received exceeded its capital losses.
The IRS denied IES’s foreign tax credits for the withholding tax, as well as the capital losses, arguing the transaction was a sham. It said IES had purchased only the rights to the net dividends. When characterized in this manner, the dividends would not exceed the capital losses. The Iowa district court where this case originated viewed the ADR transactions as tax motivated and concluded the only change in IES’s economic position as a result of the ADR transactions was the transfer of the foreign tax credit to IES. The district court granted the IRS summary judgment, and IES appealed.
Result. For the taxpayer. The Eighth Circuit Court of Appeals reversed the district court and held that the economic substance of the ADR transaction should be measured based on the gross amount of the dividend. Additionally, the court measured the business purpose test—the taxpayer’s subjective intent—in light of its right to “decrease the amount of what otherwise would be [its] taxes, or altogether avoid them, by means which the law permits … “( Gregory v. Helvering, 293 US 465, 55 S.Ct. 266 (1935)). This line of reasoning suggests the courts may respect such a tax-motivated transaction if it has economic substance even if the tax considerations are more important.
Contrary to this decision, in Compaq Computer Corp. v. Commissioner, 113 TC 214 no. 17 (1999), the Tax Court held that similar ADR trades did not have business purpose or economic substance and were sham transactions. The IES decision, however, is different from Compaq (now before the Fifth Circuit Court of Appeals) in two respects. First, in IES, under the objective economic substance test, the Eighth Circuit defined the amount of income that should be considered when measuring economic substance as the gross dividend. In Compaq , the Tax Court considered the economic benefit to be the dividend, net of withholding taxes. Second, under the business purpose test, the Eighth Circuit distinguished IES’s ADR transactions from Compaq , noting that IES met twice about the transactions and consulted outside accountants and securities counsel for reassurance on the legality of the transactions and their tax consequences. In Compaq , the Tax Court concluded the expected tax benefits of the ADR transaction, rather than the non-tax-related benefits, motivated the company.
The IES case contradicts IRS notice 98-5 (1988-1CB 334), which characterizes such scenarios as a type of “abusive tax-motivated transaction,” and notice 2000-15 (2000-12 IRB 2/29/2001), which classifies such scenarios as per-se corporate tax shelters that taxpayers must disclose and tax promoters must list under the corporate tax shelter regulations.
Pending further developments, such as the Compaq appeal, taxpayers should continue to treat notice 98-5 as in full force and effect. If the Fifth Circuit reverses Compaq, the Bush administration must decide whether to
Renew the Clinton administration’s push to enact the principles of notice 98-5 by legislation.
Move forward with the notice 98-5 regulations project without new legislation based on implicit interpretive authority under the existing foreign tax credit provisions.
Abandon the regulations project and rely on subsequently enacted IRC section 901(k) to limit dividend arbitrage transactions. Section 901(k) establishes a 15-day holding period out of the 30 days bracketing a dividend period as a condition for claiming a foreign tax credit for dividend withholding taxes.
IES Industries, Inc. v. United States, 253 F3d 350 (8th Cir. 2001).
Prepared by Lawrence Witner, JD, an associate at PricewaterhouseCoopers LLP in Atlanta.