UNITED STATES TAX COURT



Trafficking in Foreign Tax Credits: A Case

Study of Compaq Computer Corporation

Alan L. Tucker, Ph.D.

Associate Professor of Finance

Lubin School of Business

Pace University

One Pace Plaza

New York, NY 10038

212-346-1874

atucker@pace.edu

2 May 2001

Trafficking in Foreign Tax Credits: A Case

Study of Compaq Computer Corporation

Preface

This paper describes a complex tax sham perpetrated by Compaq Computer Corporation and presumably many other U.S. firms during the 1990’s. Using a novel trading strategy designed to exploit the tax code and accounting regulations, Compaq purchased what would otherwise be unusable foreign tax credits held by tax-exempt institutions, likely pension funds that held American Depository Receipts for international diversification. These tax-exempt institutions were paid for selling their foreign tax credits occasioned by foreign withholding taxes on dividend income. Obscure trading regulations promulgated by the Securities and Exchange Commission and the New York Stock Exchange facilitated the trading strategy. Recently, a U.S. Federal District Tax Court ruled that Compaq’s strategy lacked economic substance and was a sham. Recent changes to the Internal Revenue Code presumably preclude this type of trading strategy from being implemented in the future.

I. Introduction

On September 16, 1992, Compaq Computer Corporation engaged in a series of twenty-three transactions involving the purchase and nearly instantaneous resale of over $880 million worth of Royal Dutch Petroleum’s American Depository Receipts listed on the New York Stock Exchange. As this paper will demonstrate, Compaq had no purpose, substance or utility for the trades apart from capturing a foreign tax credit. Moreover, Compaq had no reasonable possibility of profit before the application of U.S. tax provisions. There was virtually no risk of loss to Compaq from engaging in the transactions. Collectively, the trades represented a carefully planned and pre-arranged strategy designed by Twenty-First Securities Corporation (TFSC), wherein the original owners (lenders) of the American Depository Receipts sold to Compaq an otherwise unusable foreign tax credit that Compaq could utilize.

This paper proceeds as follows: The next section details the trading strategy. Sections III and IV analyze the returns and risks of the trading strategy. Profits to all other parties are identified in the penultimate section. Section VI concludes the paper by describing recent tax court rulings and tax code changes occasioned by this remarkable case.

II. Summary of Compaq’s Trading of Royal Dutch Petroleum’s American Depository Receipts

On September 16, 1992, Compaq Computer Corporation bought from and then immediately sold to the same party 10 million American Depository Receipts (ADRs) of the Royal Dutch Petroleum Company (RDP) of the Netherlands. The transactions were sponsored and structured by Twenty-First Securities Corporation (TFSC), a New York brokerage firm, under a strategy it designed that enabled Compaq to acquire a foreign tax credit resulting from dividend capture.[1]

The essentials of the program are as follows:

Following a meeting in Houston, Texas, on September 15, 1992, between Compaq officers and TFSC representatives, Compaq agreed to undertake the transactions as spelled out by TFSC.

Bear, Stearns Securities Corp., TFSC’s clearing broker,[2] searched the market, located and borrowed the ADRs from institutional investors (such as pension funds or other tax-exempt institutions[3]) and banks and other brokerage firms (who held ADRs for unidentified investors believed to be tax-exempt) for short selling to Compaq. Arthur J. Gallagher & Co., an insurance broker and client of TFSC, was engaged by the latter as the short-seller.

In accordance with prior arrangements by TFSC, in a series of 23 cross-trades completed within a 1-hour time span, Gallagher sold short the ADRs to Compaq at prevailing (but, as will be discussed shortly, blended) market prices plus the expected net dividend. In each case, Compaq then immediately--within 71 seconds (and, in at least 17 of the cross trades, within 8 seconds)--sold back the securities to Gallagher at the same price less the net dividend. The trades are listed in Table 1 (Purchases by Compaq) and Table 2 (Sales by Compaq) and the clock times of the trades are provided in Table 3.

[Table 1 here]

[Table 2 here]

[Table 3 here]

In the actual execution of the trades on the NYSE trading floor,[4] both the sales and purchases were made by the same broker who made it known that cross trades were intended at prevailing market prices. The trading of the 10 million shares was broken down into 23 different trades of smaller blocks of shares, apparently due to Gallagher’s unwillingness to commit more than $20 million.[5] This amount, which accommodated a maximum position of $40 million given the margin requirement of 50%, was used as the basis for establishing the largest number of shares permissible for a single block (450,494), given the ADR price.[6] Under the strategy, this price was $88.7915 [thus giving $40,000,000/88.7915 = 450,494, the block size], i.e., the net dividend per share of $1.9165 plus $86.875, the ex-dividend price at which the Royal Dutch ADRs were traded for 14 of the 15 transactions executed between 2:15pm and 2:44pm.[7] (The last trade at 2:44pm occurred 14 minutes before the Compaq-Gallagher cross-trades commenced at 2:58pm.) However, when the cross-trades commenced the prevailing (ex-dividend) market price had changed to $86.75, hence the net dividend plus prevailing price (1.9165 + 86.75) was $88.6665. To keep to the pre-arranged agreement, the ADRs had to be sold to Compaq at exactly this price. However, at the time, NYSE prices were quoted in increments of $0.125 and it was therefore not possible to sell the ADRs to Compaq at exactly $88.6665. The closest possible prices were $88.625 and $88.75. Therefore, to obtain the exact desired average price per share of $88.6665, the 450,494 shares for each of the first six trades were split into two blocks of 300,929 and 149,565 shares respectively and sold at different prices at the same time, as follows (see Tables 1 and 2):

300,929 shares at $88.625 = $26,669,832.63

149,565 shares at $88.750 = $13,273,893.75

--------------

Total for 450,494 shares = $39,943,726.38

Weighted average price per share = $39,943,726.38/450,494

= $88.6665

Similarly, when the ex-dividend market price changed again to $86.875[8], requiring the plus-net-dividend sale price to increase to $88.7915, the subsequent trades (7 through 23) were each split accordingly and the two blocks were sold at $88.75 and $88.875 respectively at the same time, to give a weighted average ADR price of $88.7915 per share (see Table 1).

It is, however, not possible in normal stock trading to trade two blocks of the same stock at different prices at exactly the same time. Obviously, TFSC, ABD, and Compaq were able to do this because it was so pre-arranged.

Compaq’s purchases totaled $887,577,130 (before commissions and margin interest) while the sales amounted to $868,412,130 (before commissions and fees). The $19,165,000 difference is equivalent to the $1.9165 per share net dividend.

Essentially, the cross trades were arranged so that the transactions effectively worked out as follows: As of the trading date (September 16, 1992), Royal Dutch had already declared a dividend on its ADRs, to be paid on October 2, 1992. The dividend record date was September 18, 1992, and the ADR went ex-dividend on September 14, 1992. To enable Compaq to capture the declared dividend, the company purchased the ADRs with a special settlement date of September 17, 1992--since this settlement date preceded the record date. Compaq was entitled to the declared dividend. The ADRs, however, were already selling in the market at the ex-dividend price; hence, as structured by TFSC with a special settlement date, Compaq paid the prevailing market price plus the net dividend (gross dividend net of foreign withholding tax) that would be due the holder of the ADR.[9] Compaq then sold back the ADRs at the same price less the net dividend (which in this case was the prevailing ex-dividend price, see Tables 1 and 2) with a regular settlement date, i.e., settlement in five days after the trading date--September 21, 1992.

Compaq agreed to pay commission to TFSC of $0.05 per ADR traded, i.e., $1,000,000 for the 20 million ADRs traded (purchases and sales).

Compaq also paid margin interest (at 4.75%) totaling $457,845.73 for the ADR purchase and SEC fees of $28,947 on its sale of the ADRs.

On October 2, 1992, Compaq’s reported gross dividend from RDP’s ADRs was $22,545,800. Of this amount, $3,381,870, i.e., the 15% Netherlands withholding tax on the dividends, was withheld by RDP. Thus, Compaq received a net dividend payment of $19,163,930.

On October 2, 1992, apparently because the actual dividend payment Compaq got was less than its loss on the ADR trades by $1,070 ($19,165,000 - $19,163,930), TFSC reduced the commission it charged Compaq by this difference, from $999,999.45 to $998,929.45. (TFSC canceled and replaced one of the trades and reduced the commission charged on it by $1,070.)

Compaq claimed a foreign tax credit of $3,382,050 for 1992 in connection with the taxes withheld on the dividend payment.

The summary of Compaq’s transactions is provided in Schedule 1 below. This schedule shows that the ADR strategy designed by TFSC had the economic effect of enabling Compaq to purchase a 34-cent per share tax credit at a net cost of 21 cents per share.

A schematic of the various transfers of securities and cash flows involved in the transaction is provided in Figure 1.

Schedule 1: Summary of Compaq Transactions

Average Price

Total Value per share

Purchase of ADRs (before commissions

and margin interest) $887,577,130 $88.7577

Sale of ADRs (before commissions

and fees) 868,412,130 86.8412

------------ ---------

Loss ($19,165,000) ($1.9165)

Transactions Costs

Commissions on ADR

Purchase & Sale $999,999.45

Adjustment of Commission (1,070)

------------

Net Commission paid ($ 998,929) ($0.0999)

Margin Interest ( 457,846) ( 0.0458)

SEC Fees ( 28,947) ( 0.0029) Margin Interest Earned 1 0.0000

------------- ---------

Total Transactions Costs ($ 1,485,721) ( 0.1486)

Net Loss on Purchase/Sale (A) ($20,650,721) ($2.0651)

============= =========

Gross Dividends Declared $22,545,800 $2.2546

Less: Dutch Taxes Withheld 3,381,870 0.3382 ------------- ---------

Net Dividend Received (B) $19,163,930 $1.9164

============= =========

Net Cash Flow (before U.S. Taxes) (A+B): ($ 1,486,791) ($0.15)

U.S. Income Tax ($ 643,954) ($0.06)

------------- --------

Net Cash Flow after U.S. Income Tax ($ 2,130,745) ($0.21)

Foreign Tax Credit $ 3,382,050 $0.34

------------- --------

Net Cash Flow after U.S. Taxes $ 1,251,305 $0.13

============= ========

FIGURE 1

TRANSACTIONS: COMPAQ’S TRADING OF ROYAL DUTCH PETROLEUM ADRs

1. Lenders receive interest on ADR loan

Lend ADRs 2. Get in lieu dividends 3. Get back ADRs

ADRs 1. Margin Interest

+ ADRs 2. Commissions

$1000 Returned 3. SEC fees

Sale of ADRs to Compaq

ADRs sold back to

Gallagher at ex-

dividend prices

Dividend

Payment

III. Analysis of Compaq’s Returns Including and Excluding the Foreign Tax Credit

The analysis in this section shows that it was not possible for Compaq to make an economic profit from the ADR transactions absent the foreign tax credit and Compaq’s ability to utilize it.

As outlined in the last section, Compaq’s loss arising from the ADR trades was $19,165,000 and transactions costs or friction (commissions, margin interest, and SEC fees) totaled $1,485,721. The company’s net dividend on the ADRs was $19,163,930, and it claimed a foreign tax credit of $3,382,050.

Let:

NDIV = Net Dividend [$19,163,930]

FTC = Foreign Tax Credit [$3,382,050]

FRICT = Friction [$1,485,721]

LOSS = Loss on cross-trade (before friction) [$19,165,000]

TAXR = U.S. corporate tax rate [34%]

Then the expected economic return from the ADR transaction can be represented as follows:

Equation 1:

Expected economic return =(NDIV + FTC - LOSS - FRICT) X (1 - TAXR)

If NDIV = LOSS, then

Equation 2:

Expected economic return = (FTC - FRICT) X (1 - TAXR)

Equation 2 shows that if the loss occasioned by the cross trades is exactly equal to the expected net dividends (as intended and pre-arranged by TFSC and Compaq), the sole source of economic returns from the transaction is the foreign tax credit.

Assuming a 34% corporate tax rate, Compaq’s expected return (ex ante) from the transaction, using equation 1, was:

Expected return($000s)= ($19,164+$3,382-$19,165-$1,486)X(1-0.34)

= ($3,381 - $1,486) X (1 - 0.34)

= $1,895 X (1 - 0.34)

= $1,251

In the absence of an ex ante expectation of the foreign tax credit and the ability to utilize it, the economic benefits that Compaq could have expected are the dividends and any gains from the trades to recover the transaction costs. However, as of September 16, 1992, when Compaq decided to proceed with the transaction, Royal Dutch had already declared dividends. Compaq therefore knew precisely the amount of dividend income it would receive, and the arrangement to purchase the ADRs with a special settlement date was designed to capture this dividend. Also, Compaq and TFSC had already agreed on the commission rate of 5 cents per share. Compaq also knew that it would incur margin interest, which was estimated with reasonable accuracy. Compaq thus could estimate ex ante, and with reasonable accuracy, that its transactions costs would approximate the $1.486 million figure.

Compaq’s expected loss, for all economic purposes, without the tax credit would then have been:

Equation 3:

$19,165 - $19,165 - $1,486 = $(1,486)

Thus, absent the tax credit, Compaq could only have counted on a significant increase in the price of the Royal Dutch ADRs to recover the transactions costs and provide some positive return from the transaction. (An average increase of about $0.15 per ADR for the 10 million ADRs would have been necessary just to recover the transactions costs.) However, since the prior arrangement was that the ADRs would be sold at ex-dividend prices immediately after they were bought, there was clearly no expectation of capital appreciation: the ADRs were sold back nearly instantaneously so as to virtually eliminate the risk of adverse price movements, which equally removed the opportunity to profit from favorable price changes. TFSC deliberately took steps to eliminate such risk, such as making sure that the transactions took place when the markets in London and Amsterdam were closed, in order to remove the possible adverse impact of unfavorable news on the ADR prices.

The primary motivation for the transaction was therefore to capture the tax credit that could not be claimed by the original (tax-exempt) owners of the ADRs (who therefore were given an economic incentive to lend out the securities). More specifically, Compaq’s motivation for engaging in the transactions was that capturing the foreign tax credit effectively enabled it to eliminate payment of U.S. tax on more than $8 million of gross income [i.e., $2,738,096 (the net reduction in U.S. tax) divided by 34% (the U.S. tax rate), which is $8,053,224]. Indeed, TFSC’s marketing documents for the transactions presented the strategy as an arbitrage opportunity that would enable its client to reap a profit by purchasing a $1 dividend for only $0.85.[10] Thus the $0.15 profit results from the foreign tax credit.

The U.S. tax components of the transactions for Compaq are:

Tax savings on transactions loss: 0.34 x 1,487 = 506 ($000s)

Tax on grossed-up dividend withheld: 0.34 x 3,382 = (1,150)

Foreign tax credit: = 3,382

-------

Net reduction effect of U.S. taxes: 2,738

Less net cash flow before U.S. taxes (1,487)

-------

Net cash flow after U.S. taxes: 1,251

=======

Yet another way of demonstrating that Compaq’s return was solely attributable to the captured foreign tax credit is to analyze the cash inflows and outflows from Compaq’s perspective. The following cash flow summary shows that Compaq’s net cash flow from the transactions is negative until the foreign tax credit is utilized:

Funds wired to Bear Stearns (9/17/92) ($20,651,996)

Funds received from Bear Stearns:

Dividend Payment (10/2/92) $19,163,930

Check sent on 10/13/92 1,312 19,165,242

------------ -----------

Cash Inflow before U.S. Taxes ($1,486,754)

U.S. Income Tax ($ 643,954)

Foreign Tax Credit 3,382,050 2,738,096

------------ ------------

Net Cash Inflow after U.S. Taxes $ 1,251,342

============

The foregoing shows that Compaq expended close to $1.5 million in transactions costs solely to obtain a return occasioned by the foreign tax credit. The transactions costs translated into the economic incentive for the involvement of all the other entities in the transactions: TFSC’s commissions on the trades; Bear Stearns’ clearing fees and margin interest; payments to Gallagher for the short-selling and re-purchase function; income earned by the ADR lenders and their broker agents; and payments to the floor broker. Analyses of the returns obtained by these other participants are presented in Section V.

IV. Analysis of Trade Risks

The potential risks associated with Compaq’s transactions were limited to: (1) the possible break-up of the cross trades; (2) the risk of trading halts; (3) the risk of a price change between paired cross trades; (4) the possibility that a sufficient number of ADRs to accommodate the size of the short trades could not be secured, i.e., execution risk; (5) the failure of Royal Dutch to pay the declared dividends; (6) the default risk of Bear Stearns; and (7) the foreign exchange risk associated with converting dividends from Dutch guilders to U.S. dollars.

(1) Break-Up Of Cross Trades. The break-up of cross trades in progress could potentially have undermined the prior arrangement to buy and sell the ADRs. However, the probability of the Compaq trades being broken up was infinitesimal. The floor specialist for the Royal Dutch ADRs, Frank Delaney III of Merrill Lynch, and TFSC officers acknowledge in deposition testimony that, even though other traders had the opportunity to interfere with cross-trades, break-ups were rare and there was little chance that cross-trades such as Compaq’s would be broken up. In particular, because of their large sizes, there was almost zero probability that the Royal Dutch trades would be broken up. For such unusual trades of large size and number, a brokerage firm would usually have researched the market and determined that it could execute the cross trades without the risk of a break-up. And in the event that there was a risk of break-up, the firm could elect to execute the cross-trade at another exchange, if possible. It was therefore highly unlikely that other brokers would have jumped into the Compaq trades. First, since the trades were executed at the market, there was no economic incentive for other traders to interfere. Second, given the sizes and volume of the trades, any trader that chose to interfere would have needed considerable financial outlay immediately. Furthermore, in a market place with clearly understood standards of decorum and where reputation is important to survival, other traders were highly unlikely to interfere, knowing that the transactions had been pre-arranged and would have no impact on the overall market price of the shares.

(2) The Risk of a Trading Halt. Another possibility was that an exogenous and important informational event could have broken up the cross trades by causing a halt in the trading of Royal Dutch’s ADRs, but this was unlikely due to the intra-minute outstanding position in each cross trade. There were only a few seconds between the initiation of the first leg and the completion of each cross trade. As Table 3 shows, of the 21 trades for which times are available, four trades required 71, 45, 36, and 24 seconds respectively to complete, and the other 17 transactions each required an average of less than five seconds. (It should be kept in mind that some of the elapsed time during a trade is attributable to the process of recording the transaction.)

Also, as noted earlier, by arranging to have the cross trades take place only after the European markets were closed, TFSC ensured that it was highly unlikely that there would be any information about Royal Dutch that could lead to a halt in the trading of the ADRs or even a fluctuation in the price.

(3) The Risk of a Price Change Between Paired Cross Trades. There was virtually no risk that the price of Royal Dutch’s ADR would change between paired cross trades, which would have disrupted the strategy by changing the desired differential between the purchase and sale prices (i.e., the net dividend), because both legs of each cross trade were executed nearly simultaneously (see Table 3).

(4) Execution Risk. Bear Stearns could have failed to (a) secure all of the ADRs to be shorted or (b) secure lending (collateral) to cover the short sale. The consequence for Compaq would have been that it simply could not capture as much of the foreign tax credit as it originally anticipated, hence reducing expected dividend income and the tax credit. However, the company’s transaction costs would also be reduced in direct proportion to the reduction in income, since commissions, margin interest, and SEC fees were all variable costs incurred on a per share basis. There were no fixed transactions costs, therefore Compaq would not have suffered any loss even if no ADRs were secured by Bear Stearns. It is, however, possible that after the short-sale and re-purchase of the ADRs by Gallagher on September 16, 1998, Bear Stearns could have failed to obtain all the ADRs it needed to cover the short sale by the settlement date. (Clearly, Bear Stearns could not have allowed trades to proceed on a block of ADRs that it had not already been assured were available for lending by the lenders or their broker agents. However, it is possible that despite these assurances,the lenders may have failed to deliver the ADRs.) If this happened, Compaq would have received an in lieu payment from Gallagher rather than the actual dividend payment from Royal Dutch. While Compaq would receive the same amount of cash flow, it would,however not have had any foreign taxes withheld and therefore no foreign tax credit to claim. Compaq would thus have incurred a loss equal to the transactions costs. Either scenario (i.e., if Bear Stearns failed to secure the ADRs prior to the trades or after the trades at settlement) points to the fact that there was no utility from the trades other than that occasioned by the foreign tax credit.

(5) Non-Payment of Dividends. Once declared, the dividend becomes an obligation of Royal Dutch. The failure of Royal Dutch to pay all or part of its declared dividends would have resulted in a significant loss to Compaq, having taken a $19.165 million capital loss from the trades by selling back the ADRs at ex-dividend prices. However, the risk that Royal Dutch, a top international oil conglomerate, would have defaulted on payment of declared dividends was virtually nil. At the time, Royal Dutch held cash amounting to about five times the amount of its dividend [5,145,000,000/(1.916339 X 536,074,088) = 5.01].[11] Hence the firm had sufficient short-term liquidity to assure payment of the dividend.

Furthermore, according to Standard and Poor’s Stock Guide, Royal Dutch had paid dividends every year since 1947. Also, in 1992, Value Line accorded the firm its highest stock ranking for safety (1) as well as an A++ for financial strength. Similarly, Standard & Poor’s accorded the stock its second highest ranking (A) for strong historical growth in earnings and dividends and relative current standing. A highly rated multinational firm such as Royal Dutch would have had to be essentially bankrupt to default on its dividends within 16 days of Compaq’s transactions. According to a recent Moody’s study on corporate default rates,[12] during 1938-95, only one firm rated A, two related firms rated Aa, and none rated Aaa on January 1 of a calendar year defaulted during the same year.[13] The study reports that the one-year default rates during the 1970-95 period were 0.00%, 0.03%, and 0.01% for Aaa-, Aa-, and A-rated firms respectively.[14]

Thus, given the short period (16 days) following the trades before Compaq was to receive dividend payments, the probability of Royal Dutch defaulting on dividend payments was almost zero.

(6) The Default Risk of Bear Stearns. Compaq faced the risk of losing the margin it paid to Bear Stearns as well as the dividends (which were paid through Bear Stearns) in the event the latter suffered financial distress. However, at the time, Bear Stearns’ parent company was highly rated: its short-term debt (commercial paper) rating was P-1 (Moody’s), the highest possible, and its corporate bond was rated A2. Thus, as discussed above in the case of Royal Dutch, the probability of failure of Bear Stearns was very small and, given the short period (4 days) of Compaq’s exposure, there was virtually no risk of loss of the margin payment. Also, the dividend payment received by Bear Stearns was in turn wired to Compaq on the same day. Therefore, there essentially was no risk of loss of the dividend payment.

(7) Foreign Exchange Rate Risk. There was a potential foreign exchange rate risk for Compaq only if Royal Dutch dividends were declared/paid in guilders and the guilder/dollar rate changed adversely between the declaration or trade date and the actual dividend payment date. However, there was no exchange rate risk associated with Compaq’s trades because companies such as Royal Dutch immediately converted their ADR dividends into U.S. dollars; and, even in those cases where the dividends were not immediately converted, the currency exposure could easily have been hedged in the forward market. Such hedging would normally be done by the correspondent bank. In any case, even if this was not the bank’s standard practice with respect to Royal Dutch ADRs, TFSC knew that such hedging could easily be done at relatively little cost and would have incorporated it within the ADR strategy. Exchange rate risk was therefore nonexistent and was not a consideration in the transactions.

The foregoing shows that there was virtually no risk of loss or reasonable possibility of profit (absent tax factors) to Compaq from engaging in the ADR transactions.

V. Returns to TFSC, Bear Stearns, Gallagher and the ADR Lenders

As noted in Section III, the $1.486 million transactions costs incurred by Compaq translated into income for the other principal participants in the transactions:

Margin Interest. Compaq paid to Bear Stearns margin interest at a rate of 4.75% (Brokers Call Rate + 0.75%) over the 4 days between the settle-in and settle-out dates (September 17-21). Bear Stearns and TFSC shared the margin interest as follows:

Rate Amount

Bear Stearns: 4.25% (4.25/4.75) X $457,846 = $409,652

TFSC 0.50% (0.50/4.75) X $457,846 = $ 48,194

------ --------

4.75% $457,846

====== ========

Commission. The total commission of $999,999.45 charged to Compaq, adjusted by ($1,070) to $998,929.45, was paid out as follows:

Net Commissions $998,929

Bear Stearns: Clearance fees (200,000)

ABD-NY Inc. Broker’s fees* ( 3,450)

SEC fees-Gallagher Sales (paid by TFSC) ( 29,586)

Fee paid to Gallagher (by TFSC)** ( 1,000)

Commission paid to TFSC agent (383,275)

---------

Net Commission earned by TFSC $381,619

=========

*ABD charged TFSC $150 per paired cross trade (the buy and the sell) rather than per cross trade (per buy or per sell) as would usually be done in stock trading; this was apparently because it was known through pre-arrangement that the transactions would be instantaneous round-trip trades.

**TFSC paid Gallagher $1,000 for its short sale and re-purchase function. To meet margin requirements for the day trades, by arrangement, Gallagher wired an amount equal to the margin required for the largest dollar transaction of the day ($20 million). Bear Stearns then wired the funds within the same day back to Gallagher. Thus, Gallagher did not incur any interest costs on the funds, and continued to earn interest on the funds at its depository bank. Gallagher’s account with Bear Stearns was as follows:

$

ADR Sales 887,547,544

ADR Purchases 868,412,130

-----------

Gain on trades 19,135,414

SEC fees reimbursed by TFSC 29,586

-----------

Net Gain on Trades 19,165,000

In lieu dividend payment

to ADR lenders (19,163,930)

------------

Net Profit 1,070

Fees Received 1,000

It is worthy of note that the short sales and purchases of ADRs by Gallagher would normally involve incurring transactions costs (commissions, SEC fees, margin interest), but in this case Gallagher paid no commissions or margin interest, and SEC fees were paid by TFSC. The whole motivation for short selling is the expectation of a price decline that is large enough to provide gains to cover transactions costs and provide the short-seller with significant returns commensurate with risk. Obviously, as noted in Section IV, with the pre-arranged instantaneous sale and re-purchase, this was not the motivation in the Gallagher-Compaq transactions.

Parties’ Cash Flows from Compaq. In sum, the cash flows for each of the participants based on the foregoing are as follows:

COMPAQ

Net Commissions Paid $998,929

Margin Interest Paid 457,846

SEC Fees 28,947

Margin Interest Income (1)

-----------

$1,485,721

===========

TFSC:

Share of commission $381,619

Share of margin interest 48,194

--------

$429,813

TFSC Agent:

Share of commission $383,275

GALLAGHER

Payment from TFSC $1,000

BEAR STEARNS

Clearance fees from TFSC $200,000

Margin interest from Compaq 409,652

-------

$609,652

SEC

Fees from Compaq $28,947

Fees from TFSC (Gallagher sales) 29,586

------

$58,533

ABD-NY Brokers fees $3,450

=========

TOTAL $1,485,723

=========

The foregoing thus shows how Compaq’s costs translated into earnings for all of the other entities in the ADR transactions.

To protect the interests of the ADR lenders, Bear Stearns was required to post with the lenders or their broker agents cash amounting to 102% of the market value of the ADRs it borrowed over the 4-day period. (The additional 2% covered the already declared net dividends (after withholding tax) that were due to the ADR owners but were yet to be paid.) Royal Dutch’s closing ADR prices during September 17-20 averaged $88.21875, therefore the average amount of the 102% collateral posted by Bear Stearns was $882,187,500 X 102% = $899,831,250. Assume that:

(a) Bear Stearns’ funding cost for this amount was presumably the federal funds rate, which ranged between 2.875% and 3.25% during the period; and

(b) The ADR lenders invested the cash posted by Bear Stearns in securities yielding between 3.875% and 4.25%.

The short interest rebate, i.e., the share of the yield on the cash posted that Bear Stearns got from the ADR lenders on the various blocks of ADRs borrowed from different sources, ranged between 2.5% and 3.125% and averaged about 2.83%.[15] In each case, based on prior compensation arrangements, the ADR lenders and/or their respective broker/agent financial institutions shared the spread between the rate earned on the posted cash and the short interest rebate paid to Bear Stearns. (The original owners of the ADRs presumably were sophisticated institutional investors who would have asked for compensation for lending out the ADRs. The broker agents would therefore have worked out an acceptable compensation arrangement with them). For example, Bear’s short interest rebate for the ADRs borrowed from the Bank of New York (BONY) was 2.875%. If BONY earned 4.25% on the cash posted by Bear to cover the ADRs, then the bank retained 1.375% [= 4.25% - 2.875%], which it presumably shared with the original ADR owner(s).[16]

Assuming that the rate earned by the ADR lenders on the cash posted by Bear Stearns averaged 4% (which is conservative), and Bear Stearns’ short interest rebate averaged 2.83%, the cash flows that went to the ADR lenders/owners are estimated as follows:

(4.00% - 2.83%) X (4/360) X $899,831,250 = $116,978.

Thus, the ADR lenders and their broker agents had earned about $117,000. This figure represents their incentive to lend their ADRs, i.e., to sell their unusable foreign tax credits to Compaq.

VI. Conclusion

Recent estimates indicate that U.S. corporations collectively shelter $10 billion in revenues annually by engaging in various and often elaborate tax shams.[17] This case study detailed how Compaq Computer Corporation engaged in a complex trading strategy that allowed it to shelter over $8 million of taxable income. The strategy essentially entailed the purchase of unusable foreign tax credits from tax-exempt institutions. The strategy was designed by Twenty-First Securities Corporation and in effect created a secondary marketplace for idle tax credits held by tax-exempt institutions that owned dividend-paying American Depository Receipts. Presumably, many other U.S. corporations participated in the same trafficking of foreign tax credits throughout the 1990’s.

In a recent U.S. Federal Tax Court ruling,[18] the Court found that Compaq had no economic purpose for engaging in the trades and the sole purpose for the trades was the sheltering of taxable income. As a result, the U.S. Commissioner for Internal Revenue disallowed Compaq’s write-off stemming from the trades. In essence, the Court ruled that Compaq artificially engineered a tax credit through trades that otherwise lacked economic substance.

To preclude such trafficking in the future, the Internal Revenue Code was recently changed so that a U.S. corporation could only claim the foreign tax credit from the dividend withholding tax if it held the ADR for at least 15 days. This change effectively defeats the trading strategy because the corporation would be faced with the possibility of adverse price changes (real capital losses) in the ADR for the period. Corporate treasury officers do not have an appetite for such risk as they are motivated in part by job preservation. For readers who think that such price risk could still be controlled through the trading of derivatives, be aware that the changes in the Code similarly disallow the write-off should economic exposure during the 15-day period be controlled via zero-cost collars and other hedging strategies.

Table 1

Compaq-Gallagher Trades of Royal Dutch Petroleum’s

American Depository Receipts

I. Purchases by Compaq from Gallagher

Trade Date: September 16, 1992

Settlement Date: September 17, 1992

Weighted

Number of Average Total Trade Total Cost

Trade ADRs Traded Price/ADR Price Commission of Trade

-------------------------------------------------------------------------------------------------------------------------

1 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

2 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

3 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

4 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

5 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

6 450,494 88.6665 $39,943,726.25 $22,524.70 $39,966,250.95

7 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

8 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

9 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

10 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

11 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

12 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

13 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

14** 450,494 88.7915 $40,000,038.00 $21,454.70** $40,021,492.70

15 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

16 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

17 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

18 450,494 88.7915 $40,000,038.00 $22,524.70 $40,022,562.70

19 447,302 88.7915 $39,716,615.53 $22,365.10 $39,738,980.63

20 446,826 88.7915 $39,674,350.78 $22,341.30 $39,696,692.08

21 426,048 88.7915 $37,829,440.99 $21,302.40 $37,850,743.39

22 405,291 88.7915 $35,986,395.83 $20,264.55 $36,006,660.38

23 165,641 88.7915 $14,707,512.85 $ 8,282.05 $14,715,794.90

-------------- -------------------- --------------- --------------------

10,000,000 $887,577,129.48 $498,930.00 $888,076,059.48

**Trade canceled and replaced to adjust commission by ($1,070).

Note: In the actual trades, each cross-trade was split into two blocks to obtain the desired weighted average prices. Bear Stearns and TFSC combined the trades and averaged the price/share for their records and reporting to their clients. The splits were as follows:

(Table 1 Continued)

Trades 1-6: Split to obtain weighted average price of $88.6665:

300,929 ADRs at $88.625 = $26,669,832.63

149,565 ADRs at $88.750 = $13,273,893.75

--------------

Total for 450,494 shares = $39,943,726.38

Weighted average price per share = $39,943,726.38/450,494 = $88.6665

Trades 7-23: Split to obtain weighted average price of $88.7915:

Trades 7-18: 300,929 ADRs at $88.750 = $26,707,448.75

149,565 ADRs at $88.875 = $13,292,589.38

--------------

Total for 450,494 shares = $40,000,038.13

Weighted average price per share = $40,000,038.13/450,494 = $88.7915

Trade 19: 298,797 ADRs at $88.750

148,505 ADRs at $88.875

Trade 20: 298,479 ADRs at $88.750

148,347 ADRs at $88.875

Trade 21: 284,600 ADRs at $88.750

141,448 ADRs at $88.875

Trade 22: 270,734 ADRs at $88.750

134,557 ADRs at $88.875

Trade 23: 110,648 ADRs at $88.750

54,993 ADRs at $88.875

Table 2

Compaq-Gallagher Trades of Royal Dutch Petroleum’s

American Depository Receipts

II. Sales by Compaq to Gallagher

Trade Date: September 16, 1992

Settlement Date: September 21, 1992

Number of Total Trade SEC Net Proceeds

ADRs Traded Price/ADR Price Commission Fees of Trade

-------------------------------------------------------------------------------------------------------------------------------------

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.750 $39,080,354.50 $22,524.70 $1,302.68 $39,056,527.12

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

450,494 $86.875 $39,136,666.26 $22,524.70 $1,304.56 $39,112,837.00

447,302 $86.875 $38,859,361.26 $22,365.10 $1,295.32 $38,835,700.84

446,826 $86.875 $38,818,008.76 $22,341.30 $1,293.94 $38,794,373.52

426,048 $86.875 $37,012,920.00 $21,302.40 $1,233.78 $36,990,383.82

405,291 $86.875 $35,209,655.63 $20,264.00 $1,173.66 $35,188,217.97

165,641 $86.875 $14,390,061.88 $ 8,282.05 $ 479.67 $14,381,300.16

-------------- --------------------- --------------- -------------- --------------------

10,000,000 $868,412,129.64 $499,999.45 $28,947.17 $867,883,183.02

Note: For record-keeping purposes and reporting to its client, Bear Stearns divided the actual trades in half to accommodate its computer program limitations for computing SEC fees.

Table 3

Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs

September 16, 1992

TIME AS ELAPSED NUMBER OF

OBS. TRADE REPORTED TIME (secs) BUY/SELL PRICE SHARES

1 1 2:58:04PM BUY 88.625 300,929

2 2:58:30 BUY 88.750 149,565

3 2:58:40 36 SALE 86.750 450,494

4 2 2:58:47 BUY 88.625 300,929

5 2:58:50 BUY 88.750 149,565

6 2:58:53 06 SALE 86.750 450,494

7 3 2:59:35 BUY 88.625 300,929

8 2:59:40 BUY 88.750 149,565

9 2:59:43 08 SALE 86.750 450,494

10 4 3:01:19 BUY 88.625 300,929

11 3:01:22 BUY 88.750 149,565

12 3:01:23 04 SALE 86.750 450,494

Information for Trades #5 and #6 missing

13 7 3:05:22 BUY 88.750 300,929

14 3:05:23 BUY 88.875 149,565

15 3:05:25 03 SALE 86.875 450,494

16 8 3:09:37 BUY 88.750 300,929

17 3:09:40 BUY 88.875 149,565

18 3:09:42 05 SALE 86.875 450,494

19 9 3:12:33 BUY 88.750 300,929

20 3:12:36 BUY 88.875 149,565

21 3:12:37 04 SALE 86.875 450,494

22 10 3:13:07 BUY 88.750 300,929

23 3:13:08 BUY 88.875 149,565

3:13:12 05 SALE 86.875 450,494

24 11 3:16:06 BUY 88.750 300,929

25 3:16:08 BUY 88.875 149,565

26 3:16:11 05 SALE 86.875 450,494

Table 3 (Continued)

Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs

September 16, 1992

TIME AS ELAPSED NUMBER OF

OBS. TRADE NO. REPORTED TIME (secs) BUY/SELL PRICE SHARES

27 12 3:16:22 BUY 88.750 300,929

28 3:16:24 BUY 88.875 149,565

29 3:16:26 04 SALE 86.875 450,494

30 13 3:16:39 BUY 88.750 300,929

31 3:16:41 BUY 88.875 149,565

32 3:16:43 04 SALE 86.875 450,494

33 14 3:16:54 BUY 88.750 300,929

34 3:16:57 BUY 88.875 149,565

35 3:16:59 05 SALE 86.875 450,494

36 15 3:17:11 BUY 88.750 300,929

37 3:17:13 BUY 88.875 149,565

38 3:17:14 03 SALE 86.875 450,494

39 16 3:17:29 BUY 88.750 300,929

40 3:17:32 BUY 88.875 149,565

41 3:17:34 05 SALE 86.875 450,494

42 17 3:17:40 BUY 88.750 300,929

43 3:17:44 BUY 88.875 149,565

44 3:17:45 05 SALE 86.875 450,494

45 18 3:17:51 BUY 88.750 300,929

46 3:17:54 BUY 88.875 149,565

47 3:17:56 05 SALE 86.875 450,494

48 19* 3:56:35 BUY 88.750 298,797

49 3:56:37 BUY 88.875 148,505

50 3:56:59 24 SALE 86.875 447,302

51 20 3:56:42 BUY 88.750 298,479

52 3:56:47 BUY 88.875 148,347

53 3:57:53 71 SALE 86.875 446,826

54 ** 3:57:17 BUY 86.750 298,720**

Table 3 (Continued)

Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs

September 16, 1992

TIME AS ELAPSED NUMBER OF

OBS. TRADE NO. REPORTED TIME (secs) BUY/SELL PRICE SHARES

55 22 3:57:35 SALE 86.875 405,291

56 3:57:39 BUY 88.875 134,557

57 3:57:41 06 BUY 88.750 270,734

58 21 3:57:45 SALE 86.875 426,048

59 3:57:47 BUY 88.875 141,448

60 3:57:49 04 BUY 88.750 284,600

62 23 3:58:09 BUY 88.750 110,648

63 3:58:37 BUY 88.875 54,993

64 3:58:54 45 SALE 86.875 165,641

*Beginning at this point, a number of trades appear to be reported out of order.

**This trade appears to be a duplicate of the first trade of Trade #19.

Source: Institute for the Study of Security Markets, University of Memphis.

-----------------------

[1]According to deposition testimony of TFSC officers, the firm had also arranged hundreds of similar transactions for other clients during the 1990’s.

[2]TFSC was the introducing broker--because it was a small brokerage firm and not a member of the New York Stock Exchange (NYSE), TFSC engaged Bear Stearns, a major brokerage firm and member of the Exchange, to clear the ADR transactions.

[3]As discussed shortly, the whole transaction was occasioned by the fact that ADRs could be borrowed from a tax-exempt institution that had no utility for the foreign tax credit but would still receive dividends that were net of the foreign tax. TFSC’s marketing documents for the transactions noted that the strategy was facilitated by the fact that pension funds and other tax exempt entities, who had significant holdings of ADRs as a result of increased global investing, could not utilize the foreign tax credit.

[4]ABD-NY Securities, Inc. (now Dresdner Securities) was the floor broker that executed the trades on the floor of the New York Stock Exchange.

[5]Gallagher wired $20 million to Bear Stearns on September 18, 1992.

[6]Because the transactions were day trades--the purchase and sale of the same security on the same day--NYSE regulations allowed payment of margin on only the highest open position, rather than on the total value of all purchases made during the day, i.e., 10 million shares.

[7]Fitch Report of Individual Stock Sales, September 16, 1992.

[8]As the Fitch report shows, other (non-Compaq-Gallagher) transactions were executed at this price after 3.00pm.

[9]NYSE regulations allowed transactions to be undertaken in this manner.

[10]An Arbitrage Opportunity For U.S. Investors With Capital Gains, TFSC marketing document.

[11]Data from Standard & Poor’s Stock Reports, 1993.

[12]Moody’s Investors Service, Corporate Bond Defaults and Default Rates 1938-1995, Special Report, January 1996.

[13]Johns Manville Corporation, which defaulted on its debt on August 26, 1982, was rated A on January 1, 1982. DFC Financial (Overseas) Ltd. and DFC Overseas Investment Ltd., rated Aa3 on January 1, 1989, defaulted on October 3, 1989. Moody’s defines default as any missed or delayed disbursement of interest and/or principal. The rating agency also notes that its ratings are not simply statements about the probability of a default, but rather are statements about protection against credit loss (Moody’s, op. cit., p. 7).

[14]The one-year default rate is defined as the number of rated issues defaulting over a calendar year divided by the number of rated issuers outstanding at the beginning of the year, adjusted downward to reflect issuers withdrawn from the sample over the course of the year (Moody’s, op. cit., p. 9).

[15]Open Contracts by Security Report, September 17, 1992 through September 21, 1992.

[16]Also, by arrangement, TFSC got 1.25% (based on 100% and not 102% of the market value of the ADRs) out of the short interest rebate paid to Bear Stearns.

[17] See "IRS Says About 25 Companies Evaded $4Billion in Taxes in Improper Shelters," The Wall Street Journal, 5 March 2001, p. A4.

[18] See Compaq Computer Corporation and Subsidiaries, Petitioner, v. Commissioner of Internal Revenue, Respondent, United States Tax Court Dckt. No. 24238-96. Also see "Court Disallows $3.4 Million Tax Credit by Compaq," The Dallas Morning News, 22 September 1999, p. 6D.

-----------------------

TAX EXEMPT ADR LENDERS

BEAR STEARNS -- Clearing Broker

TWENTY-FIRST SECURITIES -- Introducing Broker

COMPAQ

GALLAGHER

(Short-seller)

ROYAL DUTCH

(ADR)

................
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