*. Honorable Leonard I. Garth, Senior U.S. Circuit

Judge for the United States Court of Appeals for the

Third Circuit, sitting by designation. 

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No. 95-2110

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Brown Group, Inc. and *

its Subsidiaries, *

 *

Appellant, *

 *

v. * Appeal from the United States

 * Tax Court

Commissioner of *

Internal Revenue, *

 *

Appellee. *

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Submitted: December 14, 1995

Filed: January 25, 1996 

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Before FAGG, Circuit Judge, GARTH,* Senior Circuit Judge, WOLLMAN,

Circuit Judge.

GARTH, Senior Circuit Judge.

This is an appeal from the en banc decision by the United

States Tax Court (the "Tax Court"), assessing taxes against

appellant, the Brown Group, Inc. ("the Brown Group") and its

subsidiaries, on the commission distributions received by the Brown

Group's wholly-owned Cayman Islands subsidiary, Brown Cayman, Ltd.

("BCL"), under Subpart F of the Internal Revenue Code (codified at

26 U.S.C. § 951 et seq.).

The issue we address on appeal is whether BCL's distributive
2

share of a foreign partnership's earnings (Brinco partnership)

should be taxed to the Brown Group under Subpart F of the Internal

Revenue Code. We hold that a foreign partner's distributive share

of foreign partnership income cannot be deemed to be "Subpart F

income" where the commissions at issue did not constitute "Subpart

F income" under the pre-1987 statute, 26 U.S.C. § 954(d)(3), in

that the foreign partnership (Brinco) did not control a controlled

foreign corporation such as BCL. Accordingly, we vacate the

decision of the Tax Court assessing an income tax deficiency

against the Brown Group for the tax year ending November 1, 1986.

I.

The Brown Group is the publicly traded parent corporation of

an affiliated group of corporations filing a consolidated income

tax return. The Brown Group, whose principal place of business is

St. Louis, Missouri, manufactured and sold footwear in the United

States. The Brown Group imported footwear from Brazil and other

countries and, up until 1985, used a number of independent agents

to purchase Brazilian-manufactured footwear.

The Brown Group includes a wholly owned subsidiary, Brown

Group International, Inc. ("BGII"), a Delaware corporation. BGII,

in turn, is the parent of a wholly owned subsidiary, BCL, a Cayman

Islands corporation. The parties have stipulated that BGII was a

"United States shareholder" of BCL, and that BCL was a "controlled

foreign corporation" ("CFC") within the meaning of the pre-1987

statutes, 26 U.S.C. §§ 957(a), 954(d)(1). Indeed, BCL is a CFC
2. Presti owned Pidge, Inc., which in turn held a wholly-owned

subsidiary, T.P. Cayman, Ltd. T.P. Cayman held a 10% interest in

Brinco. Birck held a 2% interest in Brinco. 

3

even under the post-1987 section 954(d)(1) as amended.

In 1985, the Brown Group decided to consolidate its buying

power in Brazil by using only one purchasing agent there. The

Brown Group formed Brinco P/S ("Brinco"), a limited foreign

partnership, to be that purchasing agent, with the view toward

attracting Mr. Ted Presti and Mr. Delcio Birck to purchase

Brazilian footwear exclusively for the Brown Group. Brinco was

structured as a partnership because this allowed the Brown Group to

pay Presti a salary higher than that allowed within the Brown

Group's existing payroll structure. It also allowed Presti and

Birck to have entrepreneurial interests in Brinco's operations;

and enabled the partners to avoid Brazilian currency instability.

Presti was the managing partner of Brinco. BCL held an 88%

interest in Brinco, with the other 12% held by the other partners.2

For ease in understanding the relationship of the various

companies to which we have made reference, we include a schematic

diagram of the various enterprises. This diagram appeared in both

parties' briefs on appeal.
4

 +))))))))))))))), 

 * BROWN GROUP, * TED PRESTI

 * INC. * * 

 .)))))))0)))))))- * 

 * 100% * 100% 

 +)))))))))2))))))))), +)))))))))2))))))))), 

 * BROWN GROUP * * PIDGE, INC. * 

 * INTERNATIONAL, INC* * *

 .)))))))))0)))))))))- .)))))))))0)))))))))-

 * 100% * 100% 

 +)))))))2))))))), +))))))))))2)))))))))),

 * BROWN CAYMAN, * * T.P. CAYMAN, LTD. * DELCIO BIRCK

 * LTD. * * * *

 .)))))))0)))))))- .))))))))))0))))))))))- * 

 * 88% * 10% * 2%

 * 64444444444N44444444447 * 

 .))))))))))))))M BRINCO K)))))))))- 

 5 PARTNERSHIP 5 

94444444444444444444448 

During 1985 and 1986, Brinco served as the purchasing agent

for BGII with respect to footwear manufactured in Brazil. BGII

paid Brinco a 10% commission for acting as its Brazilian purchasing

agent. This commission was based on the purchase price of the

footwear. BGII included the commissions paid to Brinco in its cost

of goods sold. All of Brinco's income consisted of commission

income. BCL, as a partner owning a 88% interest in Brinco,

received a distributive share of Brinco's income. Brinco was

dissolved on October 31, 1987.

On October 7, 1991, the IRS issued a Notice of Deficiency

against the Brown Group in the amount of $388,992.85 for the tax

year which ended November 1, 1986, on the ground that BCL's

distributive share of Brinco's earnings was "foreign base company

sales income" that was includable as "Subpart F income" taxable to

the Brown Group under sections 951, 952, 954, and 701-709 of the

Internal Revenue Code.
5

On January 2, 1992, the Brown Group filed a petition for

redetermination of the IRS's assessment of an income tax

deficiency. The case was tried before Tax Court Judge Julian

Jacobs on March 9, 1993. On April 12, 1994, Judge Jacobs filed an

opinion in favor of the Brown Group.

The IRS moved for reconsideration by motion filed May 12,

1994, contending that Judge Jacob's opinion was "unnecessarily

broad and can reasonably be interpreted in a manner that

effectively repeals virtually all of the subpart F provisions of

the Code." The motion for reconsideration was granted on September

27, 1994, and the case was resubmitted to the entire Tax Court.

Without further briefing or argument, the Tax Court ordered

that decision be entered for the IRS on January 25, 1995. Seven

judges (Halpern, Hamblen, Parker, Cohen, Swift, Parr, and Beghe,

JJ.) joined in the majority opinion. Of the seven judges, two

judges (Swift and Beghe, JJ.) filed or joined in separate

concurrences. Two judges who had not joined the majority opinion

(Ruwe and Chiechi, JJ.) each filed separate concurrences. Three

judges (Jacobs, Chabot, and Laro, JJ.) joined in a dissent authored

by Judge Jacobs.

On January 30, 1995, the Tax Court entered its decision

assessing an income tax deficiency in the amount of $388,992.85

against the Brown Group for the tax year ending November 1, 1986.

The Brown Group has appealed to this Court.
3. Because the tax year at issue is 1986, the Internal Revenue

Code that was in effect in 1986 applies to this case. Therefore,

except as otherwise identified, all of the references to the

Internal Revenue Code in this opinion are to the version of those

sections of the Code that existed in 1986. 

4. A "United States shareholder" is a "United States person"

who owns or is considered as owning 10% or more of the total

combined voting power of all classes of stock entitled to vote,

of a controlled foreign corporation. 26 U.S.C. § 951(b). A

"United States person" includes a citizen or resident of the

United States, a domestic partnership, a domestic corporation,

and certain trusts and estates. 26 U.S.C. §§ 957(d),

7701(a)(30).

5. A "controlled foreign corporation" is any foreign

corporation of which more than 50% of the total combined voting

power of all classes of stock entitled to vote is owned or is

considered as owned by "United States shareholders" on any day

during the taxable year. 26 U.S.C. § 957(a).

6

II.3

A.

Under Subpart F of the Internal Revenue Code, codified at 26

U.S.C. § 951 et seq., a United States shareholder4 that controls a

foreign corporation for an uninterrupted period of thirty or more

days must include in its taxable gross income, its pro rata share

of the controlled foreign corporation's "Subpart F" income. 26

U.S.C. § 951(a)(1).5

"Subpart F income" is defined as four types of income under

section 952(a). The only type of "Subpart F income" involved in

this case is "foreign base company income." 26 U.S.C. § 952(a)(2).

There are five different types of "foreign base company

income," as defined under section 954(a). The only type involved

in this case is "foreign base company sales income."

"Foreign base company sales income" is defined in relevant
7

part as:

Income . . . derived in connection with the purchase of

personal property from any person and its sale to a related

person, or the purchase of personal property from any person

on behalf of a related person where --

(A) the property which is purchased . .

. is manufactured, produced, grown, or

extracted outside the country under the laws

of which the controlled foreign corporation is

created or organized, and

(B) . . . in the case of property

purchased on behalf of a related person, is

purchased for use, consumption, or disposition

outside such foreign country.

26 U.S.C. § 954(d)(1) (emphases added). 

Under the version of section 954(d)(3) in effect for the

taxable year of 1986, a "related person" is defined as:

(A) an individual, partnership, trust, or estate which

controls the controlled foreign corporation; or (B) a

corporation which controls, or is controlled by, the

controlled foreign corporation; or (C) a corporation

which is controlled by the same person(s) which control

the controlled foreign corporation.

26 U.S.C. § 954(d)(3) (emphases added). We are concerned here only

with section 954(d)(3)(a) which requires that in order to be a

"related person," Brinco, a foreign partnership, must control a

controlled foreign corporation - in this case, BCL. For purposes

of this section, "control" is defined as "the ownership, directly

or indirectly, of stock possessing more than fifty percent of the

total combined voting power of all classes of stock entitled to

vote." Id.

B.

In this case, the parties have stipulated that BGII is a

"United States shareholder" and BCL is a "controlled foreign
8

corporation." It is undisputed that Brinco was not a "related

person," as defined in 26 U.S.C. § 954(d)(3), to either BCL or

BGII. It is also undisputed that BGII was a "related person" to

BCL. The IRS has conceded that Brinco was not a sham partnership.

III.

The present case boils down to a very discrete question of

law: whether BCL's distributive share of Brinco's partnership

earnings (commissions) constituted "Subpart F income," under 26

U.S.C. § 954(d)(3), given that the commissions did not constitute

"Subpart F income" when earned by Brinco. We exercise de novo

review of this question of law. Jacobson v. Commissioner, 963 F.2d

218, 219 (8th Cir. 1992).

We hold that the Tax Court erred in ignoring the partnership

entity in characterizing BCL's earnings as taxable "Subpart F

income." Instead, we are persuaded by, and adopt, the reasoning

and holding of Judge Jacobs's January 25, 1995 opinion which

dissented from the Tax Court's en banc opinion.

It is not disputed that under section 954(d)(3), as that

statute existed in 1986, Brinco was not a "related person" to

either BGII or BCL. Moreover, this conclusion is supported by the

plain language of the statute. Brinco is not a corporation.

Hence, the only portion of the "related person" definition that

could apply to Brinco is that of a "partnership . . . which

controls the controlled foreign corporation." 26 U.S.C. 

§ 954(d)(3)(A). However Brinco did not control BCL but rather was
6. At oral argument the IRS argued that BGII is a "related

person" because it is related to BCL, and that Brinco was

therefore earning its commission income "on behalf of" a "related

person." The IRS provides no authority for its conclusion that

by "related person," the pre-1987 version of section 954(d)(3)

meant to reach persons unrelated to the entity allegedly earning

the Subpart F income (Brinco).

Furthermore, even if we were to accept the IRS's broad

interpretation of "related person," it is irrelevant to the

present inquiry because Brinco is not a controlled foreign

corporation, and therefore its income, whether earned on behalf

of a "related person" or not, cannot be characterized as Subpart

F income.

9

controlled by BCL. Thus, Brinco was not a "related person" to

BGII. It follows therefore that BGII was not a person "related" to

Brinco.6

Because Brinco earned its commission income on behalf of an

unrelated person, BGII, that income was not "foreign company sales

income" for purposes of Subpart F. Given that partnership income

is characterized at the partnership level, the income earned by

Brinco retained its character of being not "Subpart F income" when

distributed to BCL. Accordingly, BGII (and thus its parent, the

Brown Group), under the pre-1987 version of section 954(d)(3),

cannot be assessed income tax on Brinco's partnership earnings

which were distributed to BCL.

We find this analysis to be consistent with the wellestablished principle that income is to be characterized at the

partnership level and that such income retains its character when

distributed to the individual partners.

In United States v. Basye, 410 U.S. 441 (1973), for example,

the Supreme Court held that individual partners must include as

taxable income, their distributive share of payments made to a
7. In Basye, the Court upheld the partnership principle that

the partners were required to pay taxes on their distributive

shares even in the situation where none of the partners were

eligible to receive the amounts in his contingent or tentative

account prior to retirement, even though no interest in the

account was deemed to vest in a particular beneficiary before

retirement, and even though a partner could forfeit his interest

in the retirement trust fund under a number of circumstances,

such as by taking pre-retirement severance. Id. at 441, 444-45.

10

retirement trust fund that was compensation to the partnership for

services rendered by the partnership. The Court recited a familiar

principle of income taxation to the effect that "partners are

taxable on their distributive or proportionate shares of current

partnership income irrespective of whether that income is actually

distributed to them." Basye, U.S. at 447-48.7 In the instant

case, of course, Brinco's commissions were actually distributed to

its partners in the respective proportions to which they were

entitled. Hence BCL received 88% of the commissions earned by

Brinco.

The Court in Basye further stated that:

[W]hile the partnership itself pays no taxes, 26 U.S.C.

§ 701, it must report the income it generates and such

income must be calculated in largely the same manner as

an individual computes his personal income. For this

purpose, then, the partnership is regarded as an

independently recognizable entity apart from the

aggregate of its partners. Once its income is

ascertained and reported, its existence may be

disregarded since each partner must pay a tax on a

portion of the total income as if the partnership were

merely an agent or conduit through which the income is

passed.

Id. at 448. "The legislative history indicates, and the

commentators agree, that partnerships are entities for purposes of

calculating and filing informational returns but that they are
8. Section 702(b) of Subpart K provides that:

The character of any item of income . . . in a

partner's distributive share under paragraphs (1)

through (7) of subsection (a) shall be determined as if

such item were realized directly from the source from

which realized by the partnership, or incurred in the

same manner as incurred by the partnership.

26 U.S.C. § 702(b) (emphases added). 

11

conduits through which the taxpaying obligation passes to the

individual partners in accord with their distributive shares." Id.

at 448 n. 8. See, e.g., Pleasant Summit Land Corp. v.

Commissioner, 863 F.2d 263, 272 (3d Cir. 1988) (in determining

whether individual partners can claim losses from partnership's

purchase of property, the analysis must be made of the investment

from the point of view of the partnership, not of the individual

partners), cert. denied, 493 U.S. 901 (1989); Davis v.

Commissioner, 74 T.C. 881, 895 (1980) (stating that the language of

§ 702(b) "has been consistently interpreted to mean that the

character of partnership income is determined at the partnership

level"), aff'd, 746 F.2d 357 (6th Cir. 1984).8

Although our holding may result in a tax windfall to the Brown

Group due to the particularized definition of "related person"

under the pre-1987 version of section 954(d)(3) of the Internal

Revenue Code, such a tax loophole is not ours to close but must

rather be closed or cured by Congress. MCA, Inc. v. United States,

685 F.2d 1099, 1104-05 (9th Cir. 1982) (refusing to expand the pre1987 definition of "related person" to include controlled

partnerships). Indeed, Congress has done just that. It closed
12

this loophole the following year, in 1987, when it amended section

954(d)(3) to broaden the definition of "related person" to include

not only partnerships that control CFC's but also those that are

controlled by CFC's or their parents.

Furthermore, for transactions occurring on and after December

30, 1994, Congress for the first time has apparently permitted, in

special circumstances not relevant here, the recasting of

partnership income under Subpart F. It did so by issuing Treasury

Regulation § 1.701-2 ("anti-abuse rule" permitting the IRS to

recast partnership transactions that make inappropriate use of

Subchapter K rules) and in particular § 1.701-2(e) (providing that

the IRS can treat a partnership as an aggregation of its partners

in whole or in part as appropriate to carry out the purpose of any

provision of the Code or regulations). However, because section

1.701-2 is effective only for transactions on or after May 12,

1994, and section 1.701-2(e) is effective only for transactions on

or after December 29, 1994, those provisions cannot apply to this

case. Indeed, as we read the regulations, the IRS does not have

the power to recast partnership transactions or apply the aggregate

approach for transactions occurring prior to these effective dates.

Because the "loophole" in Subpart F taxable income has been

closed, the issue that arises in the present case is unlikely to

occur again. Under the pre-1987 law applicable to the instant

case, however, the Brown Group cannot be held taxable on BCL's
9. At oral argument, the IRS invoked the language of 26 U.S.C. 

§ 702(b) of Subpart F of the Internal Revenue Code that states

that the character of the partner's income is determined as if

the partner directly realized that income from the source from

which the partnership realized the income. However that same

section also provides that the income "shall be determined as if

such item were . . . incurred in the same manner as incurred by

the partnership." 26 U.S.C. § 702(b). See n. 8, supra. We do not find section 702(b) to shed much light on the

present inquiry and, in any event, we conclude that it is

unnecessary to reach or address Subpart K in resolving the

instant controversy.

13

distributive share of Brinco's partnership earnings.9

IV.

For the foregoing reasons, the Tax Court erred in attributing

taxable "Subpart F income" to the Brown Group based on BCL's

distributive share of Brinco's earnings. The decision of the Tax

Court assessing an income tax deficiency against the Brown Group

for the tax year ending November 1, 1986 is vacated.

A true copy.

Attest:

CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.