Compaq Computer Corporation and Subsidiaries v. Commissioner , 113 T.C. No. 17 ( 1999 )

113 T.C. No. 17UNITED STATES TAX COURT
COMPAQ COMPUTER CORPORATION
AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24238-96. Filed September 21, 1999.
In a prearranged transaction designed to eliminate
typical market risks, P purchased and immediately
resold American Depository Receipts (ADR's) of a
foreign corporation on the floor of the NYSE. As a
result of the transaction, P was the shareholder of
record of 10 million ADR's on the dividend record date
and received a dividend of $22,545,800 less withheld
foreign taxes of $3,381,870. P also recognized a
$20,652,816 capital loss on the sale of the ADR's,
which was offset against previously realized capital
gains. The net cash-flow from the transaction, without
regard to tax consequences, was a $1,486,755 loss.
Held: The transaction lacked economic substance, and
the foreign tax credit claimed by P will be disallowed.
Held further: An accuracy-related penalty will be
imposed due to petitioner's negligence.
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Mark A. Oates, John M. Peterson, Jr., James M. O'Brien,
Owen P. Martikan, Paul E. Schick, Robert S. Walton, Tamara L.
Frantzen, Erika S. Schechter, A. Duane Webber, David A. Waimon,
Lafayette G. Harter III, and Steven M. Surdell, for petitioner.
Dennis M. Kelly, Ginny Y. Chung, and Rebecca I. Rosenberg,
for respondent.
COHEN, Chief Judge: The issues addressed in this opinion
are whether petitioner's purchase and resale of American
Depository Receipts (ADR's) in 1992 lacked economic substance and
whether petitioner is liable for an accuracy-related penalty
pursuant to section 6662(a). (In a separate opinion, Compaq
Computer Corp. & Subs. v. Commissioner, T.C. Memo. 1999-220, we
held that income relating to printed circuit assemblies should
not be reallocated under section 482 to petitioner from its
Singapore subsidiary for its 1991 and 1992 fiscal years.
Petitioner has also filed a Motion for Summary Judgment on the
issue of whether petitioner is entitled to foreign tax credits
for certain United Kingdom Advance Corporation Tax payments.)
Unless otherwise indicated, all section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference. Since
1982, petitioner has been engaged in the business of designing,
manufacturing, and selling personal computers. Details
concerning petitioner's business operations are set forth in T.C.
Memo. 1999-220 and are not repeated here.
Petitioner occasionally invested in the stock of other
computer companies. In 1992, petitioner held stock in Conner
Peripherals, Inc. (Conner Peripherals), a publicly traded,
nonaffiliated computer company. Petitioner sold the Conner
Peripherals stock in July 1992, recognizing a long-term capital
gain of $231,682,881.
Twenty-First Securities Corporation (Twenty-First), an
investment firm specializing in arbitrage transactions, learned
of petitioner's long-term capital gain from the sale of Conner
Peripherals, and on August 13, 1992, Steven F. Jacoby (Jacoby), a
broker and account executive with Twenty-First, mailed a letter
to petitioner soliciting petitioner's business. The letter
stated that Twenty-First "has uncovered a number of strategies
that take advantage of a capital gain", including a Dividend
Reinvestment Arbitrage Program (DRIP) and a "proprietary
variation on the DRIP", the ADR arbitrage transaction (ADR
transaction).
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An ADR (American Depository Receipt) is a trading unit
issued by a trust, which represents ownership of stock in a
foreign corporation that is deposited with the trust. ADR's are
the customary form of trading foreign stocks on U.S. stock
exchanges, including the New York Stock Exchange (NYSE). The ADR
transaction involves the purchase of ADR's "cum dividend",
followed by the immediate resale of the same ADR's "ex dividend".
"Cum dividend" refers to a purchase or sale of a share of stock
or an ADR share with the purchaser entitled to a declared
dividend (settlement taking place on or before the record date of
the dividend). "Ex dividend" refers to the purchase or sale of
stock or an ADR share without the entitlement to a declared
dividend (settlement taking place after the record date).
James J. Tempesta (Tempesta) was an assistant treasurer in
petitioner's treasury department in 1992. He received his
undergraduate degree in philosophy and government from Georgetown
University and his master's degree in finance and accounting from
the University of Texas. Tempesta's responsibilities in
petitioner's treasury department included the day-to-day
investment of petitioner's cash reserves, including the
evaluation of investment proposals from investment bankers and
other institutions. He was also responsible for writing
petitioner's investment policies that were in effect during
September 1992. Petitioner's treasury department primarily
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focused on capital preservation, typically investing in overnight
deposits, Eurodollars, commercial paper, and tax-exempt
obligations.
On September 15, 1992, Tempesta and petitioner's treasurer,
John M. Foster (Foster), met with Jacoby and Robert N. Gordon
(Gordon), president of Twenty-First, to discuss the strategies
proposed in the August 13, 1992, letter from Twenty-First. In a
meeting that lasted approximately an hour, Jacoby and Gordon
presented the DRIP strategy and the ADR transaction. Following
the meeting, Tempesta and Foster discussed the transactions with
Darryl White (White), petitioner's chief financial officer. They
decided not to engage in the DRIP investment but chose to go
forward with the ADR transaction, relying primarily on Tempesta's
recommendation. Tempesta notified Twenty-First of this decision
on September 16, 1992.
Although cash-flow was generally important to petitioner's
investment decisions, Tempesta did not perform a cash-flow
analysis before agreeing to take part in the ADR transaction.
Rather, Tempesta's investigation of Twenty-First and the ADR
transaction, in general, was limited to telephoning a reference
provided by Twenty-First and reviewing a spreadsheet provided by
Jacoby that analyzed the transaction. Tempesta shredded the
spreadsheet a year after the transaction.
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Joseph Leo (Leo) of Twenty-First was responsible for
arranging the execution of the purchase and resale trades of
ADR's for petitioner. Bear Stearns & Co., Inc. (Bear Stearns),
was used as the clearing broker for petitioner's trades, and the
securities selected for the transaction were ADR shares of Royal
Dutch Petroleum Company (Royal Dutch). Royal Dutch ordinary
capital shares were trading in 21 organized markets throughout
the world in 1992, but primarily on the NYSE in the United States
as ADR's. Before agreeing to enter into the transaction,
petitioner had no specific knowledge of Royal Dutch, and
Tempesta's research of Royal Dutch was limited to reading in the
Wall Street Journal that Royal Dutch declared a dividend and to
observing the various market prices of Royal Dutch ADR's.
In preparation for the trades, Leo determined the number of
Royal Dutch ADR's to be included in each purchase and resale
trade. He also selected the market prices to be paid, varying
the prices in different trades so the blended price per share
equaled the actual market price plus the net dividend. Leo did
not, however, discuss the size of the trades or the prices
selected for the trades with any employee or representative of
petitioner. Leo also chose to purchase the Royal Dutch ADR's
from Arthur J. Gallagher and Company (Gallagher). Gallagher had
been a client of Twenty-First since 1985 and participated in
various investment strategies developed by Twenty-First over the
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years. During 1991, Gallagher participated in several ADR
transaction trades as the purchaser of the ADR's. Tempesta had
no knowledge of the identity of the seller of ADR's. He only
knew that the seller was a client of Twenty-First.
On September 16, 1992, Leo instructed ABD-N.Y., Inc. (ABD),
to purchase 10 million Royal Dutch ADR's on petitioner's behalf
from Gallagher on the floor of the NYSE. He also instructed ABD
to resell the 10 million Royal Dutch ADR's to Gallagher
immediately following the purchase trades. The purchase trades
were made in 23 separate cross-trades of approximately 450,000
ADR's each with special "next day" settlement terms pursuant to
NYSE rule 64. The aggregate purchase price was $887,577,129, cum
dividend.
ABD executed the 23 sale trades, selling the Royal Dutch
ADR's back to Gallagher, immediately following the related
purchase trade. Accordingly, each purchase trade and its related
sale trade were completed before commencing the next purchase
trade. The sales transactions, however, had regular settlement
terms of 5 days, and the aggregate sales price was $868,412,129,
ex dividend. The 23 corresponding purchase and resale trades
were completed in about an hour between approximately 2:58 p.m.
and 4:00 p.m.
Leo had instructed the ABD floor brokers to execute the
trades only if the prices selected were within the range of the
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current market prices. Thus, when, between the sixth and seventh
trades, the market price changed, Leo modified the price for
subsequent trades to compensate for the change. In addition,
NYSE rule 76 required an open outcry for each cross-trade, and
NYSE rule 72 allowed other traders on the floor or the
"specialist" responsible for making the cross-trades to break up
the transaction by taking all or part of the trade. However, for
cross-trades priced at the market price, there was no incentive
to break up the transaction.
Pursuant to the "next day" settlement rules, the purchase
cross-trades were settled between petitioner and Gallagher on
September 17, 1992. On that date, Gallagher's account with Bear
Stearns was credited $887,547,543 for the purchase trades,
including a reduction for Securities and Exchange Commission fees
(SEC fees) of $29,586. Gallagher was subsequently reimbursed for
the SEC fees. Also on September 17, 1992, petitioner transferred
$20,651,996 to Bear Stearns, opening a margin account.
On September 18, 1992, at 10:47 a.m., petitioner complied
with the applicable margin requirements, transferring $16,866,571
to its margin account with Bear Stearns. The margin requirement
for purchase and sale transactions completed on the same day was
50 percent of the purchase price of the largest trade executed on
that day. It was not necessary to make payments for each
completed trade. Accordingly, this wire transfer was made by
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petitioner to demonstrate its financial ability to pay under the
applicable margin rules. The $16,866,571 was transferred back to
petitioner that same day at 1:39 p.m.
Pursuant to the regular settlement rules, the resale cross-
trades were settled between petitioner and Gallagher on
September 21, 1992. The total selling price credited to
petitioner's account with Bear Stearns was $868,412,129 (before
commissions and fees). Expenses incurred by petitioner with
respect to the purchase and resale trades included: SEC fees of
$28,947, interest of $457,846, a margin writeoff of $37, and
commissions of $998,929. Petitioner had originally agreed to pay
Twenty-First commissions of $1,000,000, but Twenty-First adjusted
its commissions by $1,070.55 to offset computational errors in
calculating some of the purchase trades.
Due to the different settlement dates, petitioner was the
shareholder of record of 10 million Royal Dutch ADR's on the
dividend record date and was therefore entitled to a dividend of
$22,545,800. On October 2, 1992, Royal Dutch paid the declared
dividend to shareholders of record as of September 18, 1992,
including petitioner. Contemporaneously with the dividend, a
corresponding payment was made to the Netherlands Government
representing withholding amounts for dividends paid to U.S.
residents within the meaning of the United States-Netherlands Tax
Treaty, Convention With Respect to Taxes on Income and Certain
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Other Taxes, Apr. 29, 1948, U.S.-Neth., art. VII, para. 1, 62
Stat. 1757, 1761. The withholding payment equaled 15 percent of
the declared dividend, $3,381,870. Accordingly, a net dividend
of $19,163,930 was deposited into petitioner's margin account at
Bear Stearns and wired to petitioner on October 2, 1992.
On its 1992 Federal income tax return, petitioner reported
the loss on the purchase and resale of Royal Dutch ADR's as a
short-term capital loss in the amount of $20,652,816, calculated
as follows:
Adjusted basis $888,535,869
Amount realized 867,883,053
Capital loss $ 20,652,816
Petitioner also reported dividend income in the amount of
$22,546,800 and claimed a foreign tax credit of $3,382,050 for
the income tax withheld and paid to the Netherlands Government
with respect to the dividend.
ULTIMATE FINDINGS OF FACT
Every aspect of petitioner's ADR transaction was
deliberately predetermined and designed by petitioner and
Twenty-First to yield a specific result and to eliminate all
economic risks and influences from outside market forces on the
purchases and sales in the ADR transaction.
Petitioner had no reasonable possibility of a profit from
the ADR transaction without the anticipated Federal income tax
consequences.
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Petitioner had no business purpose for the purchase and sale
of Royal Dutch ADR's apart from obtaining a Federal income tax
benefit in the form of a foreign tax credit while offsetting the
previously recognized capital gain.
OPINION
Respondent argues that petitioner is not entitled to the
foreign tax credit because petitioner's ADR transaction had no
objective economic consequences or business purpose other than
reduction of taxes. Petitioner argues that it is entitled to the
foreign tax credit because it complied with the applicable
statutes and regulations, that the transaction had economic
substance, and that, in any event, the economic substance
doctrine should not be applied to deny a foreign tax credit.
In Frank Lyon Co. v. United States, 435 U.S. 561, 583-584
(1978), the Supreme Court stated that "a genuine multiple-party
transaction with economic substance * * * compelled or encouraged
by business or regulatory realities, * * * imbued with tax-
independent considerations, and * * * not shaped solely by tax-
avoidance features" should be respected for tax purposes.
Innumerable cases demonstrate the difference between (1) closing
out a real economic loss in order to minimize taxes or arranging
a contemplated business transaction in a tax-advantaged manner
and (2) entering into a prearranged loss transaction designed
solely for the reduction of taxes on unrelated income. In the
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former category are Cottage Sav. Association v. Commissioner, 499
U.S. 554 (1991); and Esmark, Inc. & Affiliated Cos. v.
Commissioner, 90 T.C. 171 (1988), affd. without published opinion
886 F.2d 1318 (7th Cir. 1989). In the latter category are ACM
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), affg.
in part T.C. Memo. 1997-115; Goldstein v. Commissioner, 364 F.2d
734 (2d Cir. 1966); and Friendship Dairies, Inc. v. Commissioner,
90 T.C. 1054 (1988). Referring to tax shelter transactions in
which a taxpayer seeks to use a minimal commitment of funds to
secure a disproportionate tax benefit, the Court of Appeals for
the Seventh Circuit stated, in Saviano v. Commissioner, 765 F.2d
643, 654 (7th Cir. 1985), affg. 80 T.C. 955 (1983):
The freedom to arrange one's affairs to minimize taxes
does not include the right to engage in financial
fantasies with the expectation that the Internal
Revenue Service and the courts will play along. The
Commissioner and the courts are empowered, and in fact
duty-bound, to look beyond the contrived forms of
transactions to their economic substance and to apply
the tax laws accordingly. * * *
Petitioner repeatedly argues, and asks the Court to find,
that it could not have had a tax savings or tax benefit purpose
in entering into the ADR transaction because:
In this case, a tax savings or tax benefit purpose
cannot be attributed to Compaq because Compaq did not
enjoy any tax reduction or other tax benefit from the
transaction. Compaq's taxable income increased by
approximately $1.9 million as a result of the Royal
Dutch ADR arbitrage. Compaq's worldwide tax liability
increased by more than $640,000 as a direct result of
the Royal ADR arbitrage. The reason for this increase
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in income taxes is obvious--Compaq realized a net
profit with respect to the Royal Dutch ADR arbitrage.
That net profit, appropriately, was subject to tax.
Petitioner's calculation of its alleged profit is as
follows:
ADR transaction:
ADR purchase trades ($887,577,129)
ADR sale trades 868,412,129
Net cash from ADR transaction ($19,165,000)
Royal Dutch dividend 22,545,800
Transaction costs (1,485,685)
PRETAX PROFIT $1,895,115
Petitioner asserts:
Stated differently, the reduction in income tax
received by the United States was not the result of a
reduction in income tax paid by Compaq. Each dollar of
income tax paid to the Netherlands was just as real,
and was the same detriment to Compaq, as each dollar of
income tax paid to the United States. Even
Respondent's expert acknowledged this detriment, and
that Compaq's worldwide income tax increased as a
result of the Royal Dutch ADR arbitrage. A "tax
benefit" can be divined from the transaction only if
the income tax paid to the Netherlands with respect to
Royal Dutch dividend is ignored for purposes of
computing income taxes paid, but is included as a
credit in computing Compaq's U.S. income tax liability.
Such a result is antithetical to the foreign tax credit
regime fashioned by Congress.
In the complete absence of any reduction in income
tax, it is readily apparent that Compaq could not have
engaged in the transaction solely for the purpose of
achieving such an income tax reduction.
Petitioner's rationale is that it paid $3,381,870 to the
Netherlands through the withheld tax and paid approximately
$640,000 in U.S. income tax on a reported "pretax profit" of
approximately $1.9 million. (The $640,000 amount is petitioner's
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approximation of U.S. income tax on $1.9 million in income.) If
we follow petitioner's logic, however, we would conclude that
petitioner paid approximately $4 million in worldwide income
taxes on that $1.9 million in profit.
Petitioner cites several cases, including Levy v.
Commissioner, 91 T.C. 838, 859 (1988); Gefen v. Commissioner, 87
T.C. 1471, 1492 (1986); Pearlstein v. Commissioner, T.C. Memo.
1989-621; and Rubin v. Commissioner, T.C. Memo. 1989-484, that
conclude that the respective transactions had economic substance
because there was a reasonable opportunity for a "pretax profit".
These cases, however, merely use "pretax profit" as a shorthand
reference to profit independent of tax savings, i.e., economic
profit. They do not involve situations, such as we have in this
case, where petitioner used tax reporting strategies to give the
illusion of profit, while simultaneously claiming a tax credit in
an amount (nearly $3.4 million) that far exceeds the U.S. tax (of
$640,000) attributed to the alleged profit, and thus is available
to offset tax on unrelated transactions. Petitioner's tax
reporting strategy was an integrated package, designed to produce
an economic gain when--and only when--the foreign tax credit was
claimed. By reporting the gross amount of the dividend, when
only the net amount was received, petitioner created a fictional
$1.9 million profit as a predicate for a $3.4 million tax credit.
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While asserting that it made a "real" payment to the
Netherlands in the form of the $3,381,870 withheld tax,
petitioner contends that that withholding tax should be
disregarded in determining the U.S. tax effect of the transaction
and the economic substance of the transaction. Respondent,
however, persuasively demonstrates that petitioner would incur a
prearranged economic loss from the transaction but for the
foreign tax credit.
The following cash-flow analysis demonstrates the inevitable
economic detriment to petitioner from engaging in the ADR
transaction:
Cash-flow from ADR transaction:
ADR purchase trades ($887,577,129)
ADR sale trades 868,412,129
Net cash from ADR transaction ($19,165,000)
Cash-flow from dividend:
Gross dividend 22,545,800
Netherlands withholding tax (3,381,870)
Net cash from dividend 19,163,930
OFFSETTING CASH-FLOW RESIDUAL (1,070)
Cash-flow from transaction costs:
Commissions (1,000,000)
Less: Adjustment 1,071
SEC fees (28,947)
Margin writeoff 37
Interest (457,846)
Net cash from transaction costs (1,485,685)
NET ECONOMIC LOSS ($1,486,755)
The cash-flow deficit arising from the transaction, prior to use
of the foreign tax credit, was predetermined by the careful and
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tightly controlled arrangements made between petitioner and
Twenty-First. The scenario was to "capture" a foreign tax credit
by timed acquisition and sale of ADR's over a 5-day period in
which petitioner bought ADR's cum dividend from Gallagher and
resold them ex dividend to Gallagher. Petitioner was acquiring a
foreign tax credit, not substantive ownership of Royal Dutch
ADR's. See Friendship Dairies, Inc. v. Commissioner, supra at
1067.
Petitioner argues that there were risks associated with the
ADR transaction, but neither Tempesta nor any other
representative of petitioner conducted an analysis or
investigation regarding these alleged concerns. Transactions
that involve no market risks are not economically substantial
transactions; they are mere tax artifices. See Yosha v.
Commissioner, 861 F.2d 494, 500-501 (7th Cir. 1988), affg. Glass
v. Commissioner, 87 T.C. 1087 (1986). Tax-motivated trading
patterns generally indicate a lack of economic substance. See
Sheldon v. Commissioner, 94 T.C. 738, 766, 769 (1990). The
purchase and resale prices were predetermined by Leo, and the
executing floor brokers did not have authority to deviate from
the predetermined prices even if a price change occurred. In
addition, the ADR transaction was divided into 23 corresponding
purchase and resale cross-trades that were executed in
succession, almost simultaneously, and within an hour on the
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floor of the NYSE. Thus, there was virtually no risk of price
fluctuation. Special next-day settlement terms and large blocks
of ADR's were also used to minimize the risk of third parties
breaking up the cross-trades, and, because the cross-trades were
at the market price, there was no risk of other traders breaking
up the trades. None of the outgoing cash-flow resulted from
risks. Accordingly, we have found that this transaction was
deliberately predetermined and designed by petitioner and Twenty-
First to yield a specific result and to eliminate all market
risks.
To satisfy the business purpose requirement of the economic
substance inquiry, “the transaction must be rationally related to
a useful nontax purpose that is plausible in light of the
taxpayer's conduct and * * * economic situation.” AMC
Partnership v. Commissioner, T.C. Memo. 1997-115, affd. in part,
revd. in part, and remanded 157 F.3d 231 (3d Cir. 1998); see also
Levy v. Commissioner, supra at 854. This inquiry takes into
account whether the taxpayer conducts itself in a realistic and
legitimate business fashion, thoroughly considering and analyzing
the ramifications of a questionable transaction, before
proceeding with the transaction. See UPS of Am. v. Commissioner,
T.C. Memo. 1999-268.
Petitioner contends that it entered into the ADR transaction
as a short-term investment to make a profit apart from tax
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savings, but the objective facts belie petitioner's assertions.
The ADR transaction was marketed to petitioner by Twenty-First
for the purpose of partially shielding a capital gain previously
realized on the sale of Conner Peripherals stock. Petitioner's
evaluation of the proposed transaction was less than businesslike
with Tempesta, a well-educated, experienced, and financially
sophisticated businessman, committing petitioner to this
multimillion-dollar transaction based on one meeting with Twenty-
First and on his call to a Twenty-First reference. As a whole,
the record indicates and we conclude that petitioner was
motivated by the expected tax benefits of the ADR transaction,
and no other business purpose existed.
Petitioner also contends that the ADR transaction does not
warrant the application of the economic substance doctrine
because the foreign tax credit regime completely sets forth
Congress' intent as to allowable foreign tax credits. Petitioner
argues that an additional economic substance requirement was not
intended by Congress and should not be applied in this case.
Congress creates deductions and credits to encourage certain
types of activities, and the taxpayers who engage in those
activities are entitled to the attendant benefits. See, e.g.,
Leahy v. Commissioner, 87 T.C. 56, 72 (1986); Fox v.
Commissioner, 82 T.C. 1001, 1021 (1984). The foreign tax credit
serves to prevent double taxation and to facilitate international
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business transactions. No bona fide business is implicated here,
and we are not persuaded that Congress intended to encourage or
permit a transaction such as the ADR transaction, which is merely
a manipulation of the foreign tax credit to achieve U.S. tax
savings.
Finally, petitioner asserts that the enactment of section
901(k) by the Taxpayer Relief Act of 1997, Pub. L. 105-34, sec.
1053(a), 111 Stat. 941, also indicates that Congress did not
intend for the economic substance doctrine to apply under the
facts of this case. Section 901(k)(1) provides that a taxpayer
must hold stock (or an ADR) for at least 16 days of a prescribed
30-day period including the dividend record date, in order to
claim a foreign tax credit with respect to foreign taxes withheld
at the source on foreign dividends. If the taxpayer does not
meet these holding requirements, the taxpayer may claim a
deduction for the foreign taxes paid if certain other
requirements are met.
Section 901(k) does not change our conclusion in this case.
That provision was passed in 1997 and was effective for dividends
paid or accrued after September 4, 1997. The report of the
Senate Finance Committee indicates that "No inference is intended
as to the treatment under present law of tax-motivated
transactions intended to transfer foreign tax credit benefits."
S. Rept. 105-33, 175, 177 (1997). A transaction does not avoid
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economic substance scrutiny because the transaction predates a
statute targeting the specific abuse. See, e.g., Krumhorn v.
Commissioner, 103 T.C. 29, 48-50 (1994); Fox v. Commissioner,
supra at 1026-1027. Accordingly, section 901(k), enacted 5 years
after the transaction at issue, has no effect on the outcome of
this case.
Accuracy-Related Penalty
Respondent determined that petitioner is liable for the
section 6662(a) penalty for 1992. Section 6662(a) imposes a
penalty in an amount equal to 20 percent of the underpayment of
tax attributable to one or more of the items set forth in section
6662(b). Respondent asserts that the underpayment attributable
to the ADR transaction was due to negligence. See sec.
6662(b)(1). "Negligence" includes a failure to make a reasonable
attempt to comply with provisions of the internal revenue laws or
failure to do what a reasonable and ordinarily prudent person
would do under the same circumstances. See sec. 6662(c);
Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967),
affg. on this issue 43 T.C. 168 (1964); sec. 1.6662-3(b)(1),
Income Tax Regs. Petitioner bears the burden of proving that
respondent's determinations are erroneous. See Rule 142(a);
Freytag v. Commissioner, 904 F.2d 1011, 1017 (5th Cir. 1990),
affg. 89 T.C. 849, 887 (1987), affd. 501 U.S. 868 (1991).
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The accuracy-related penalty does not apply with respect to
any portion of an underpayment if it is shown that there was
reasonable cause for such portion of an underpayment and that the
taxpayer acted in good faith with respect to such portion. See
sec. 6664(c)(1). The determination of whether the taxpayer acted
with reasonable cause and in good faith depends upon the
pertinent facts and circumstances. See sec. 1.6664-4(b)(1),
Income Tax Regs. The most important factor is the extent of the
taxpayer's effort to assess the proper tax liability for the
year. See id.Respondent argues that petitioner is liable for the
accuracy-related penalty because petitioner negligently
disregarded the economic substance of the ADR transaction;
petitioner failed to meet its burden of proving that the
underpayment was not due to negligence; and petitioner failed to
offer evidence that there was reasonable cause for its return
position for the ADR transaction or that it acted in good faith
with respect to such item. Petitioner argues that there is no
basis for a negligence penalty because the return position was
reasonable, application of the economic substance doctrine to the
ADR transaction is "inherently imprecise", and application of the
economic substance doctrine to disregard a foreign tax credit
raises an issue of first impression. We agree with respondent.
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In this case, Tempesta, Foster, and White were sophisticated
professionals with investment experience and should have been
alerted to the questionable economic nature of the ADR
transaction. They, however, failed to take even the most
rudimentary steps to investigate the bona fide economic aspects
of the ADR transaction. See Freytag v. Commissioner, supra. As
set forth in the findings of fact, petitioner did not investigate
the details of the transaction, the entity it was investing in,
the parties it was doing business with, or the cash-flow
implications of the transaction. Petitioner offered no evidence
that it satisfied the "reasonable and ordinarily prudent person"
standard or relied on the advice of its tax department or
counsel. If any communications occurred in which consideration
was given to the correctness of petitioner's tax return position
when the return was prepared and filed, petitioner has chosen not
to disclose those communications. We conclude that petitioner
was negligent, and the section 6662(a) penalty is appropriately
applied.
Our holding in this opinion will be incorporated into the
decision to be entered in this case when all other issues are
resolved.