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
1
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.
2
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
3
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.
1According
to deposition testimony of TFSC officers, the firm had also arranged
hundreds of similar transactions for other clients during the 1990’s.
4

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 taxexempt institutions3) 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
2TFSC
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.
3As
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.
5
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
4ABD-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
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
6Because
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.
7Fitch
Report of Individual Stock Sales, September 16, 1992.
7
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
$86.8758, 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).
8As
the Fitch report shows, other (non-Compaq-Gallagher) transactions were
executed at this price after 3.00pm.
8
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
9
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
9NYSE
regulations allowed transactions to be undertaken in this manner.
10
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.
11
Schedule 1: Summary of Compaq Transactions
Total Value
Average
Price
per share
$887,577,130
$88.7577
868,412,130
-----------($19,165,000)
86.8412
--------($1.9165)
($
(
(
998,929)
457,846)
28,947)
1
------------($ 1,485,721)
($0.0999)
( 0.0458)
( 0.0029)
0.0000
--------( 0.1486)
Net Loss on Purchase/Sale (A)
($20,650,721)
=============
($2.0651)
=========
Gross Dividends Declared
Less: Dutch Taxes Withheld
$22,545,800
3,381,870
------------$19,163,930
=============
$2.2546
0.3382
--------$1.9164
=========
Purchase of ADRs (before commissions
and margin interest)
Sale of ADRs (before commissions
and fees)
Loss
Transactions Costs
Commissions on ADR
Purchase & Sale
$999,999.45
Adjustment of Commission
(1,070)
-----------Net Commission paid
Margin Interest
SEC Fees
Margin Interest Earned
Total Transactions Costs
Net Dividend Received (B)
Net Cash Flow (before U.S. Taxes) (A+B):
U.S. Income Tax
Net Cash Flow after U.S. Income Tax
Foreign Tax Credit
Net Cash Flow after U.S. Taxes
($ 1,486,791)
($
643,954)
------------($ 2,130,745)
$ 3,382,050
------------$ 1,251,305
=============
($0.15)
($0.06)
-------($0.21)
$0.34
-------$0.13
========
12
FIGURE 1
TRANSACTIONS: COMPAQ’S TRADING OF ROYAL DUTCH PETROLEUM ADRs
TAX EXEMPT ADR LENDERS
Lend ADRs
1. Lenders receive interest on ADR loan
2. Get in lieu dividends
3. Get back ADRs
BEAR STEARNS -- Clearing Broker
TWENTY-FIRST SECURITIES -- Introducing Broker
ADRs
+
$1000
ADRs
Returned
1. Margin Interest
2. Commissions
3. SEC fees
Sale of ADRs to Compaq
GALLAGHER
(Short-seller)
COMPAQ
ADRs sold back to
Gallagher at exdividend prices
Dividend
Payment
ROYAL
DUTCH
(ADR)
13
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%]
14
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
15
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)
16
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
17
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
=======
10An
Arbitrage Opportunity For U.S. Investors With Capital Gains, TFSC marketing
document.
18
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
------------
Cash Inflow before U.S. Taxes
U.S. Income Tax
Foreign Tax Credit
Net Cash Inflow after U.S. Taxes
19,165,242
----------($1,486,754)
($
643,954)
3,382,050
2,738,096
------------
-----------$ 1,251,342
============
19
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.
20
(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
21
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
22
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
23
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
24
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
11Data
from Standard & Poor’s Stock Reports, 1993.
25
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’
12Moody’s
Investors Service, Corporate Bond Defaults and Default Rates 19381995, Special Report, January 1996.
13Johns
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).
14The
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).
26
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
27
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:
28
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*
(
SEC fees-Gallagher Sales (paid by TFSC)
( 29,586)
Fee paid to Gallagher (by TFSC)**
(
Commission paid to TFSC agent
(383,275)
3,450)
1,000)
--------Net Commission earned by TFSC
$381,619
=========
29
*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
30
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.
31

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
Share of margin interest
$381,619
48,194
-------$429,813

TFSC Agent:
Share of commission
$383,275
32

GALLAGHER
Payment from TFSC

$1,000
BEAR STEARNS
Clearance fees from TFSC
Margin interest from Compaq
$200,000
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
=========
33
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
34
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
Open Contracts by Security Report, September 17, 1992 through September 21,
1992.
15
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.
16
35
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
17
See "IRS Says About 25 Companies Evaded $4Billion in Taxes in Improper Shelters," The Wall Street Journal, 5
March 2001, p. A4.
36
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
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.
37
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 writeoff should economic exposure during the 15-day period be
controlled via zero-cost collars and other hedging strategies.
38
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
8
9
10
11
12
13
14**
15
16
17
18
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
88.7915
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$40,000,038.00
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$21,454.70**
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,021,492.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
$40,022,562.70
19
20
21
22
23
447,302
446,826
426,048
405,291
165,641
-------------10,000,000
88.7915
88.7915
88.7915
88.7915
88.7915
$39,716,615.53
$39,674,350.78
$37,829,440.99
$35,986,395.83
$14,707,512.85
-------------------$887,577,129.48
$22,365.10
$22,341.30
$21,302.40
$20,264.55
$ 8,282.05
--------------$498,930.00
$39,738,980.63
$39,696,692.08
$37,850,743.39
$36,006,660.38
$14,715,794.90
-------------------$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:
39
(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 =
149,565 ADRs at $88.875 =
Total for 450,494 shares =
$26,707,448.75
$13,292,589.38
-------------$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
40
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
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
450,494
447,302
446,826
426,048
405,291
165,641
-------------10,000,000
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$86.875
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$39,136,666.26
$38,859,361.26
$38,818,008.76
$37,012,920.00
$35,209,655.63
$14,390,061.88
--------------------$868,412,129.64
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,524.70
$22,365.10
$22,341.30
$21,302.40
$20,264.00
$ 8,282.05
--------------$499,999.45
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,304.56
$1,295.32
$1,293.94
$1,233.78
$1,173.66
$ 479.67
-------------$28,947.17
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$39,112,837.00
$38,835,700.84
$38,794,373.52
$36,990,383.82
$35,188,217.97
$14,381,300.16
-------------------$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.
41
Table 3
Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs
September 16, 1992
OBS.
TRADE
1
2
3
1
4
5
6
2
7
8
9
3
10
11
12
4
TIME AS
REPORTED
2:58:04PM
2:58:30
2:58:40
2:58:47
2:58:50
2:58:53
2:59:35
2:59:40
2:59:43
3:01:19
3:01:22
3:01:23
ELAPSED
TIME (secs)
BUY/SELL
PRICE
NUMBER OF
SHARES
36
BUY
BUY
SALE
88.625
88.750
86.750
300,929
149,565
450,494
06
BUY
BUY
SALE
88.625
88.750
86.750
300,929
149,565
450,494
08
BUY
BUY
SALE
88.625
88.750
86.750
300,929
149,565
450,494
04
BUY
BUY
SALE
88.625
88.750
86.750
300,929
149,565
450,494
03
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
04
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
Information for Trades #5 and #6 missing
13
14
15
7
16
17
18
8
19
20
21
9
22
23
10
24
25
26
11
3:05:22
3:05:23
3:05:25
3:09:37
3:09:40
3:09:42
3:12:33
3:12:36
3:12:37
3:13:07
3:13:08
3:13:12
3:16:06
3:16:08
3:16:11
42
Table 3 (Continued)
Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs
September 16, 1992
OBS.
TRADE NO.
27
28
29
12
30
31
32
13
33
34
35
14
36
37
38
15
39
40
41
16
42
43
44
17
45
46
47
18
48
49
50
19*
51
52
53
20
54
**
TIME AS
REPORTED
3:16:22
3:16:24
3:16:26
3:16:39
3:16:41
3:16:43
3:16:54
3:16:57
3:16:59
3:17:11
3:17:13
3:17:14
3:17:29
3:17:32
3:17:34
3:17:40
3:17:44
3:17:45
3:17:51
3:17:54
3:17:56
3:56:35
3:56:37
3:56:59
3:56:42
3:56:47
3:57:53
3:57:17
ELAPSED
TIME (secs)
BUY/SELL
PRICE
NUMBER OF
SHARES
04
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
04
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
03
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
05
BUY
BUY
SALE
88.750
88.875
86.875
300,929
149,565
450,494
24
BUY
BUY
SALE
88.750
88.875
86.875
298,797
148,505
447,302
71
BUY
BUY
SALE
88.750
88.875
86.875
298,479
148,347
446,826
BUY
86.750
298,720**
43
Table 3 (Continued)
Clock Times of Twenty-three Cross Trades: Royal Dutch Petroleum ADRs
September 16, 1992
OBS.
TRADE NO.
55
56
57
22
58
59
60
21
62
63
64
23
TIME AS
REPORTED
3:57:35
3:57:39
3:57:41
3:57:45
3:57:47
3:57:49
3:58:09
3:58:37
3:58:54
ELAPSED
TIME (secs)
BUY/SELL
PRICE
NUMBER OF
SHARES
06
SALE
BUY
BUY
86.875
88.875
88.750
405,291
134,557
270,734
04
SALE
BUY
BUY
86.875
88.875
88.750
426,048
141,448
284,600
45
BUY
BUY
SALE
88.750
88.875
86.875
110,648
54,993
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.
44