1

The following cases are consolidated herewith for purposes

of trial, briefing, and opinion: InverWorld, Inc., docket No.

3441-93; InverWorld, Ltd., docket Nos. 27090-90, 3443-93 and

3444-93; and InverWorld Holdings, Inc., docket No. 3442-93. 

T.C. Memo. 1996-301

UNITED STATES TAX COURT

INVERWORLD, INC., ET AL.,1 Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 27089-90, 27090-90, Filed June 27, 1996. 

 3441-93, 3442-93,

 3443-93, 3444-93.

Turner P. Smith, Nancy E. Delaney, and Robert D. Whoriskey,

for petitioner in docket No. 27089-90.

Turner P. Smith, Nancy E. Delaney, T. Barry Kingham, and

Robert D. Whoriskey, for petitioner in docket No. 27090-90.

Turner P. Smith and Nancy E. Delaney, for petitioners in

docket Nos. 3441-93, 3442-93, 3443-93, and 3444-93.

Jill Frisch, Peter J. Graziano, and Maria Stabile, for

respondent.
- 2 -

CONTENTS

I. STATEMENT OF ISSUES .................... 8

A. Issues With Respect to LTD ............. 8

B. Issues With Respect to INC ............ 10

C. Issues With Respect to Holdings .......... 11

II. FINDINGS OF FACT .................... 11

A. Petitioners .................... 11

B. Petitioners' Returns ............... 12

C. Creation of LTD .................. 13

D. Creation of INC .................. 15

E. Structure and Operation of LTD's 

Promotion, Service, and Sales . . ......... 17

F. INC's Consulting Agreement With LTD ........ 22

G. Research ..................... 26

H. Financial Accounting and Client Statements for LTD 27

I. IRS Audit During Spring 1987 ........... 29

J. The Transition to MultiValores .......... 30

K. Accounting Firm Audit ............... 31

L. LTD's Receipts .................. 31

1. Management Fees ............... 31

2. Interest Income ............... 33

a. U.S. Certificates of Deposit

and Bank Deposits ............ 33

b. Loans .................. 38

c. Non-U.S. Certificates of Deposit

and Term Deposits . . . . . . . . .... 38

d. Pace Investments ............ 40

e. MMA II ................. 40

3. Currency Exchange Transactions Income .... 43

a. Currency Swaps ............. 43

b. Currency Transactions .......... 43

4. Sales Commissions and Fees .......... 46

a. Currency Fund .............. 46

b. FEIM Fund ................ 47

c. Matric Fund ............... 48

d. Inversat Fund .............. 49

e. TVA ................... 50

f. Client Incorporation and Trust Creation . 52

g. Legal Advice Income ........... 53

h. Letters of Credit ............ 53

i. Foreign Exchange Investments ...... 54

j. Treasury Bills ............. 54

k. Wires and Checks ............ 55

l. Gold and Silver Futures ......... 55

m. Project Income ............. 56

n. Income From Investments ......... 56
- 3 -

o. Other Commission Income/

Other Commissions and Fees ....... 57

p. Other Income .............. 57

M. Amounts Subject to Withholding Tax ........ 59

III. OPINION ........................ 62

A. Whether LTD Was Engaged in Trade

or Business Within the United States ....... 62

1. Background .................. 64

2. Section 1.864-4(c)(5)(i), Income Tax Regs.,

Engaged in a Banking Business Test ...... 64

B. Whether Each Item of LTD's Income 

Was Effectively Connected ............. 104

1. Character and Source Rules .......... 104

2. Application of the Character and Source Rules 106

a. Management Fees ............. 107

b. Service Fees .............. 107

(1) U.S. Certificates of Deposit

and Bank Deposits . . . . . .... 107

(2) Non-U.S. Certificates of Deposit 

and Term Deposits ......... 113

(3) Pace Investments .......... 114

c. Interest Income ............. 116

(1) Loans ............... 116

(2) MMA II ............... 116

d. Currency Exchange Transactions

Income (Currency Swaps

and Currency Transactions) ....... 117

e. Sales Commissions and Fees ....... 118

(1) Currency Fund, FEIM Fund,

and Matric Fund .......... 118

(2) Inversat Fund ........... 121

(3) TVA ................ 122

(4) Client Incorporation and Trust

Creation, Legal Advice

Income, and Letters of Credit ... 124

(5) Foreign Exchange Investments .... 124

(6) Treasury Bills, Wires and Checks,

Gold and Silver Futures, Project

Income, Income from Investments,

Other Commission Income, Other 

Commissions and Fees, 

and Other Income .......... 125

3. Effectively Connected Income Rules ...... 125

a. Introduction to the Rules ........ 125

b. Section 1.864-4(c)(5), Income

Tax Regs., Banking Activity Test .... 127

c. Section 864(c)(2)(A) Asset-use Test ... 128
- 4 -

d. Section 864(c)(2)(B)

Business-Activities Test ........ 129

e. Section 864(c)(4)(B) Rules for Income

From Sources Without the United States . 130

4. Application of the Effectively

Connected Income Rules ............ 135

a. Management Fees ............. 136

b. Service Fees .............. 139

(1) U.S. Certificates of Deposit

and Bank Deposits . . . . . .... 139

(2) Non-U.S. Certificates of Deposit

and Term Deposits . . . . . . . . . 143

(3) Pace Investments .......... 146

c. Interest Income ............. 149

(1) Loans ............... 149

(2) MMA II ............... 157

d. Currency Exchange Transactions

Income (Currency Swaps

and Currency Transactions) . . ..... 161

e. Sales Commissions and Fees ....... 164

(1) Foreign Source TVA Commissions ... 165

(2) All Commissions and Fees Excepting

the Foreign Source TVA Commissions . 166

C. Whether LTD and INC are Liable

for Withholding Tax . . . . . . .......... 170

1. Background .................. 170

2. Withholding Tax on Interest ......... 171

a. Pre-1986 Act Years ........... 176

(1) Character and Source

Rules for Interest . ........ 176

(2) Taxation of Interest ........ 179

b. Post-1986 Act Years ........... 180

(1) Character and Source Rules

for Interest . . . . . . . ..... 180

(2) Taxation of Interest ........ 181

3. Withholding Tax on Dividends ......... 183

a. Character and Source Rules 

for Dividends . . . . . . . ....... 183

b. Taxation of Dividends .......... 183

4. Discussion of Interest ............ 185

a. Pre-1986 Act Years ........... 185

(1) Application of the Character

and Source Rules for Interest ... 185

(2) Taxation of Interest ........ 188

b. Post-1986 Act Years ........... 189

(1) Application of the Character

and Source Rules for Interest ... 189

(2) Taxation of Interest ........ 190
- 5 -

5. Discussion of Dividend Income ........ 191

D. Whether LTD Is Entitled to Deductions ....... 194

1. Law ..................... 194

2. Discussion .................. 195

E. Whether Income Should Be Allocated

Pursuant to Section 482 . . . . . . ........ 199

1. Background .................. 199

2. Law ..................... 200

a. Section 482 in General ......... 200

b. The Section 482 Regulations ....... 203

3. Discussion .................. 208

F. Remaining Issues ................. 231

1. Positions of the Parties ........... 231

2. Issues With Respect to LTD .......... 232

3. Issues With Respect to INC .......... 232

4. Issues With Respect to Holdings ....... 232

G. Additions to Tax ................. 233

1. Section 6651(a)(1) .............. 233

2. Sections 6653(a)(1) and 6653(a)(1)(A) .... 237

3. Section 6655(a) ............... 241

4. Section 6656(a) ............... 241

5. Section 6661(a) ............... 243

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined deficiencies in and

additions to InverWorld, Ltd.'s (LTD) withholding tax as follows:

InverWorld, Ltd., Docket Nos. 27090-90, 3443-93

 Additions to Tax 

 Sec. Sec. Sec. Sec.

Year Deficiency 6651 6653(a)(1) 6653(a)(2) 6656

1984 $4,891,617 $1,222,904 $244,581 1 $489,162

1985 10,119,885 2,529,971 505,994 1 1,011,988

 Additions to Tax 

 Sec. Sec. Sec. Sec.

Year Deficiency 6651(a)(1) 6653(a)(1)(A) 6653(a)(1)(B) 6656

1986 13,506,793 3,376,698 675,340 1 1,350,679

1987 733,420 183,355 36,671 1 73,342

 Additions to Tax 

 Sec. Sec. Sec.

Year Deficiency 6651(a)(1) 6653(a)(1) 6656

1988 1,524,928 381,232 76,246 152,493

1989 2,951,566 737,891 --- 295,157
- 6 -

2

Respondent sent LTD a notice of liability for withholding

tax and a notice of deficiency in corporate income tax, each

dated Sept. 7, 1990, for its taxable years ended 1984, 1985, and

1986. LTD timely filed a petition with this Court contesting

respondent's determinations in the notice of liability. LTD

attached the notice of liability to its petition but did not

attach the notice of deficiency. In its petition, LTD did not

refer to or dispute any of the deficiencies in corporate income

tax determined in the notice of deficiency. Because LTD failed

to contest the determinations in the notice of deficiency,

respondent, on Feb. 6, 1991, assessed the amounts of the tax,

additions to tax, and interest for LTD's taxable years ended

1984, 1985, and 1986, as determined in the notice of deficiency.

After the period for filing a petition with respect to the

notice of deficiency had expired, LTD filed a motion for leave to

file amendments to its petition contesting the notice of

liability, pursuant to Rule 41(a). In InverWorld, Ltd. v.

Commissioner, 98 T.C. 70 (1992), affd. 979 F.2d 868 (D.C. Cir.

1992), we held, inter alia, that, because each notice must be

considered independently for purposes of jurisdiction, this Court

did not acquire jurisdiction over the corporate income tax

deficiencies determined in the notice of deficiency by virtue of

a petition which contested only the withholding tax

determinations in the notice of liability.

Respondent then assessed and collected $7.7 million of LTD's

corporate income tax deficiencies and additions to tax. In the

U.S. District Court for the District of Columbia, LTD has

commenced a refund action, InverWorld, Ltd. v. United States,

Civil Action No. 93-1704-LFO (D.D.C., filed Mar. 11, 1994), which

has been stayed pending resolution of the instant case. 

1 50 percent of the interest due on the deficiency.

Respondent determined deficiencies in and additions to LTD's

Federal income taxes as follows:2

InverWorld, Ltd., Docket No. 3444-93

 Additions to Tax 

Tax Year Sec. Sec. Sec. Sec. 

Sec.

 Ended Deficiency 6651(a)(1) 6653(a)(1)(A) 6653(a)(1)(B) 6655 

6656

June 30, 1987 $2,060,490 $515,123 $103,025 

1 $101,169 $206,049

June 30, 1988 2,299,853 574,963 114,993 

1 128,503 229,985
- 7 -

 Additions to Tax 

Tax Year Sec. Sec. Sec. Sec. 

 Ended Deficiency 6651(a)(1) 6653(a)(1) 6655 6656

June 30, 1989 6,828,339 1,707,085 341,417 417,253 682,834

1 50 percent of the interest due on the deficiency.

Respondent determined deficiencies in and additions to

InverWorld, Inc.'s (INC) Federal withholding taxes as follows:

InverWorld, Inc., Docket No. 3441-93

 Additions to Tax 

 Sec. Sec. Sec. Sec.

Year Deficiency 6651(a)(1) 6653(a)(1)(A) 6653(a)(1)(B) 6656

1987 $733,420 $183,355 $36,671 1 $73,342

 

 Additions to Tax 

 Sec. Sec. Sec.

Year Deficiency 6651(a)(1) 6653(a)(1) 6656

1988 1,524,928 381,232 76,246 152,493

1989 2,951,566 737,891 --- 295,157

1 50 percent of the interest due on the deficiency.

Respondent determined deficiencies in and additions to INC's

Federal income tax for taxable years ended June 30, 1985 and

1986. Subsequent to the issuance of the statutory notice and

upon submission of additional information to the District

Director, Austin, respondent determined revised deficiencies in

and additions to INC's Federal income tax as follows: 

InverWorld, Inc., Docket No. 27089-90

 

 Additions to Tax 

Tax Year Sec. Sec. Sec. 

 Ended Deficiency 6653(a)(1) 6653(a)(2) 6661

June 30, 1985 $77,851,228 $3,892,561 1 $19,462,807

June 30, 1986 157,044,730 7,852,237 1 39,261,183

1 50 percent of the interest due on the deficiency. 
- 8 -

3

LTD’s deficiencies in income tax for its taxable years ended

June 30, 1984, 1985, and 1986, are not at issue in the instant

case. See supra note 2. We must, however, decide whether LTD

was engaged in trade or business pursuant to sec. 864(b) for its

taxable years ended June 30, 1985, and 1986, in order to apply

the dividend source rules. See infra p. 174.

Respondent determined deficiencies in and additions to

InverWorld Holdings, Inc.'s (Holdings) Federal income tax as

follows: 

InverWorld Holdings, Inc., Docket No. 3442-93

 Additions to Tax 

Tax Year Sec. Sec. Sec.

 Ended Deficiency 6653(a)(1)(A) 6653(a)(1)(B) 6661

June 30, 1987 $454,333 $22,717 

1 $113,471

June 30, 1988 365,507 18,275 

1 91,377

1 50 percent of the interest due on the deficiency.

 Additions to Tax 

Tax Year Sec. Sec. Sec.

 Ended Deficiency 6653(a)(1) 6653(a)(2) 6661

June 30, 1989 1,453,333 72,667 --- 363,333

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.

I. STATEMENT OF ISSUES

The issues for decision are:

A. Issues With Respect to LTD

1. Whether LTD is engaged in trade or business within the

United States pursuant to section 864(b) for its taxable years

ended June 30, 1985 through 1989;3
- 9 -

4

LTD’s deficiencies in income tax for its taxable years ended

June 30, 1984, 1985, and 1986, are not at issue in the instant

case. See supra note 2. We must, however, decide whether each

item of LTD’s income was sourced from within or without the

United States and whether each such item was effectively

connected with the conduct of trade or business within the United

States for its taxable years ended June 30, 1985 and 1986, in

order to apply the dividend source rules. See infra p. 174.

2. if we decide that LTD is engaged in trade or business

within the United States for its taxable years ended June 30,

1985 through 1989, then we must decide whether each item of LTD’s

income was sourced from within or without the United States and

whether each such item was effectively connected with the conduct

of such trade or business within the United States;4

3. whether LTD is liable for branch profits tax pursuant

to section 884 for its taxable years ended June 30, 1988 and

1989; 

4. whether LTD is liable for environmental tax pursuant to

section 59A for its taxable years ended June 30, 1988 and 1989; 

5. whether LTD is liable for additions to corporate income

tax pursuant to sections 6651, 6653(a), and 6656 for its taxable

years ended June 30, 1987, 1988, and 1989; 

6. whether LTD is liable as a withholding agent pursuant

to sections 1441 and 1442 for failing to withhold tax on items of

income of nonresident aliens and foreign corporations derived

from sources within the United States for calendar years 1984

through 1989;
- 10 -

7. whether LTD is liable for additions to withholding tax

pursuant to sections 6651, 6653(a), and 6656 for calendar years

1984 through 1989. 

B. Issues With Respect to INC

1. Whether income should be allocated to INC pursuant to

section 482 for its taxable years ended June 30, 1985 and 1986; 

 2. whether INC is entitled to claimed deductions for legal

and audit expenses for its taxable year ended June 30, 1986; 

 3. whether the net operating loss deduction claimed by INC

should be increased for its taxable year ended June 30, 1985, and

decreased for taxable year ended June 30, 1986; 

4. whether investment credits claimed by INC should be

increased for its taxable year ended June 30, 1985, and decreased

for its taxable year ended June 30, 1986; 

5. whether INC is liable for additions to corporate income

tax pursuant to sections 6653(a) and 6661 for its taxable years

ended June 30, 1985 and 1986; 

6. whether INC is liable as a withholding agent pursuant

to sections 1441 and 1442 for failing to withhold tax on items of

income of nonresident aliens and foreign corporations derived

from sources within the United States for calendar years 1987,

1988, and 1989; 

7. whether INC is liable for additions to withholding tax

pursuant to sections 6651, 6653(a), and 6656 for calendar years
- 11 -

1987, 1988, and 1989. 

C. Issues With Respect to Holdings

1. Whether income should be allocated to Holdings pursuant

to section 482 for its taxable years ended June 30, 1987, 1988,

and 1989; 

 2. whether Holdings is entitled to claimed deductions for

legal and audit fees for its taxable year ended June 30, 1987; 

3. whether Holdings is entitled to claimed deductions for

professional and legal fees for its taxable years ended June 30,

1988 and 1989; 

4. whether Holdings is entitled to claimed deductions for

employee training and recruiting for its taxable year ended June

30, 1989; 

5. whether Holdings is liable for environmental tax

pursuant to section 59A for its taxable year ended June 30, 1989; 

6. whether Holdings is liable for additions to corporate

income tax pursuant to sections 6653(a) and 6661 for its taxable

years ended June 30, 1987, 1988, and 1989. 

II. FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91. The parties’ stipulations of facts are incorporated

herein by reference, and they are found accordingly.

A. Petitioners

LTD, an investment management and financial services
- 12 -

company, is a corporation that was organized pursuant to the laws

of the Cayman Islands on November 27, 1981. 

INC is a corporation that was organized pursuant to the laws

of the State of Delaware on December 22, 1982. At the time the

petitions in docket Nos. 27089-90 and 3441-93 were filed, INC's

principal office was at 1250 N.E. Loop 410, Suite 1030, San

Antonio, Texas 78209. During the years in issue, LTD owned,

either directly or indirectly, all of the outstanding stock of

INC. On November 15, 1985, INC was registered with the SEC as an

investment adviser pursuant to section 203 of the Investment

Advisers Act of 1940. 

Holdings is a corporation that was organized pursuant to the

laws of the State of Delaware on February 24, 1987. At the time

the petition in docket No. 3442-93 was filed, Holdings' principal

office was at 1250 N.E. Loop 410, Suite 1030, San Antonio, Texas

78209. During certain of the taxable years in issue, LTD owned

all the outstanding stock of Holdings, and Holdings was the owner

of all of the outstanding stock of INC.

B. Petitioners' Returns

LTD maintained its books and records using a June 30 taxable

year. LTD did not file U.S. Annual Withholding Tax Returns for

U.S. Source Income of Foreign Persons (Forms 1042) for calendar

years 1984, 1985, 1986, 1987, 1988, and 1989; U.S. Corporation

Income Tax Returns of a Foreign Person (Forms 1120F) for its

taxable years ended June 30, 1987, 1988, and 1989; or any other
- 13 -

U.S. tax returns for calendar years 1984, 1985, 1986, 1987, 1988,

and 1989, or its taxable years ended June 30, 1987, 1988, and

1989. During each of its taxable years ended June 30, 1984

through 1989, LTD did not file income tax returns with any

governmental entity, either foreign or domestic. LTD did not

file any statements, forms, or other documents in lieu of income

tax returns in Mexico or the Cayman Islands. 

 INC maintained its books and records using a June 30

taxable year. INC filed U.S. Corporation Income Tax Returns

(Forms 1120) for taxable years ended June 30, 1985 and 1986. INC

did not file U.S. Annual Withholding Tax Returns for U.S. Source

Income of Foreign Persons (Forms 1042) for calendar years 1987,

1988, and 1989. For its taxable years ended June 30, 1987, 1988,

and 1989, INC was joined in the consolidated income tax returns

filed by Holdings. 

Holdings maintained its books and records using a June 30

taxable year. Holdings filed U.S. Corporation Income Tax Returns

(Forms 1120) for taxable years ended June 30, 1987, 1988, and

1989. 

C. Creation of LTD

LTD was created by principals of InverMexico, S.A. de C.V.,

Casa de Bolsa, which was a securities brokerage firm that was

registered in Mexico and headquartered in Mexico City, Mexico. 

On November 27, 1981, LTD was incorporated as an exempted
- 14 -

5

An "exempted company" is one the operation of which is

conducted mainly outside the Cayman Islands. Secs. 179, 181, The

Companies Law of the Cayman Islands. 

company5 pursuant to the laws of the Cayman Islands. To maintain

its registration as an exempted company in the Cayman Islands,

LTD submitted on March 4, 1983, November 21, 1983, December 5,

1984, February 18, 1988, November 29, 1988, and December 8, 1989,

an "Annual Return and Declaration" stating, inter alia, that its

operations since its last return have been mainly outside the

Cayman Islands. 

LTD was a "sister company" of InverMexico; i.e., LTD and

InverMexico were owned by the same persons or entities. During

the years in issue, no client of LTD was a citizen or resident of

the United States. 

The principals of InverMexico managed a diverse group of

financial services companies in the name of InverMexico and other

entities; such companies were called "Grupo Inver", or the "Inver

Group". During the late 1970's and early 1980's, in the face of

Mexico's declining oil revenues, the massive devaluation of the

peso, and a growing sense of political instability, wealthy

Mexicans increasingly sought opportunities outside Mexico's

borders for investments that were considered safer than domestic

investment opportunities. In response to such "capital flight",

during those years the Mexican Government placed increasing
- 15 -

restrictions on the operations of Mexican financial institutions,

having already closed its borders to non-Mexican financial

institutions. The culmination of Mexico's restrictive investment

regime was the imposition of exchange controls by presidential

decree during September 1982 and the nationalization of the

country's private banks. From that date onward, no Mexicanchartered bank or financial institution was permitted to handle

foreign-currency-denominated accounts. Peso-based investments

lost value. During 1982, many of the accounts managed by

InverMexico were diminished as a result of the capital flight. 

Clients of InverMexico were sending their money to Merrill Lynch

in the United States and to Swiss and Japanese banks.

From its inception through its taxable year ended June 30,

1990, LTD did not file any registration statement, reporting

statement, or any other statement with any governmental entity in

Mexico. During each of its taxable years ended June 30, 1984

through 1990, LTD was not registered to do business in Mexico.

D. Creation of INC

Prior to 1983, LTD had fewer than 15 clients. For the

administration of the accounts of such clients, LTD used the

services of United States Trust Co. of New York (Cayman), Ltd.

(United States Trust); Paine Webber; and Shearson, American

Express, Inc. (Shearson). United States Trust provided basic

research, accounting, bookkeeping, reporting, and order-filling
- 16 -

services for LTD and maintained the account records of LTD's

clients. United States Trust charged commissions directly

against each individual account on a sliding scale with the

highest charge being approximately 0.75 percent of a client’s net

assets. For their equity investments, LTD clients used the

investment management services of Paine Webber and Shearson. 

Generally, Shearson charged commissions directly against an LTD

client’s account. Shearson then compensated either LTD or

InverMexico by paying a percentage of the fees or commissions

that Shearson earned from managing LTD clients' portfolios. 

After 1 year of working with United States Trust, LTD’s

principals concluded that the service provided by United States

Trust did not meet their expectations and that LTD was losing fee

revenue and possibly clients to United States Trust. The

executive committee of the Inver Group decided to create another

related company that would perform the research, bookkeeping, and

administrative services formerly provided by United States Trust. 

On December 22, 1982, INC was incorporated pursuant to the laws

of the State of Delaware for that purpose. 

The original INC office was established in New York City by

George Fahey, president and a director of INC. Mr. Fahey leased

a small space at Rockefeller Center during early 1983. INC’s

office personnel consisted of Mr. Fahey and a secretary. Mr.

Fahey maintained that office through the end of calendar year
- 17 -

1983. Notwithstanding the creation of INC, LTD's clients

continued to keep their accounts at United States Trust through

the end of 1983. 

Jose Zollino, treasurer and a director of INC, and Raymundo

Leal, chairman of the board of directors of INC, moved to San

Antonio, Texas, in August 1983. By November 1983, INC had leased

space and opened an office in San Antonio. By the end of that

year, Mr. Zollino informed Mr. Fahey that INC's management wanted

to close the New York office and to have Mr. Fahey move to San

Antonio. Mr. Fahey agreed to move to San Antonio, arriving there

on January 15, 1984. Subsequently, LTD’s clients were

transferred from United States Trust to LTD. Prior to that time,

none of the United States Trust accounts had been transferred to

LTD. For its office, INC purchased an office copier, computer

equipment and software, and office equipment and furniture.

E. Structure and Operation of LTD's 

Promotion, Service, and Sales 

As conceived by LTD's founders, LTD's business was to

provide U.S. and foreign investment opportunities to InverMexico

clients. As a foreign (i.e., non-Mexican) financial institution,

however, LTD was restricted by Mexican law in the manner by which

it could advise clients in Mexico. Accordingly, LTD chose not to

establish a direct corporate presence in Mexico. When LTD was

first established, its clients were on the client roster of

InverMexico. Additionally, clients were referred to LTD by the

principals of InverMexico (including principals of InverMexico
- 18 -

who were directors, officers, or shareholders of LTD) and by

InverMexico account executives and employees. Accordingly, LTD

depended upon referrals rather than direct marketing. 

The account executives of InverMexico (known in Mexico as

promotores and in the United States as promoters) were trained to

sell in Mexico the services of the companies within the Inver

Group, including LTD. For clients who were interested in

Mexican, peso-based investments, an account would be opened at

InverMexico. For clients who were interested in dollar deposits

or other investments outside Mexico, an account would be opened

at LTD. The number of client accounts at LTD was approximately

70 during 1984, 257 during 1985, 434 during 1986, 557 during

1987, 870 during 1988, and 1,131 during 1989. Not all client

accounts were actively traded. For those years, the total

amounts of client assets placed with LTD were $42,627,253 during

1984; $82,808,357 during 1985; $135,861,724 during 1986;

$166,544,045 during 1987; $291,002,145 during 1988; and

$285,621,179 during 1989. 

Each promoter earned compensation for services rendered in

the form of a salary and bonus from InverMexico. Promoters also

earned "commissions", which did not follow a strict formula in

any one year. In some cases, a promoter might also have received

a commission directly from LTD. 

Promoters presented new clients with a package of account

opening documents, which consisted of signature cards, an
- 19 -

Investment Management Agreement/Discretionary Authorization

(discretionary authorization), the client’s investment

instructions, and a power of attorney. The promoter explained

the investment options available to the client and received the

client's executed copies of the documents. It was the promoter's

obligation to verify the facts presented in the account opening

documents, including the fact that the client was not a resident

or citizen of the United States 

Each signature card contained the client’s name and

signature, the client’s LTD account number, and, generally, the

client’s address. The discretionary authorization signed by each

client granted LTD the "sole discretion" to invest the client’s

assets in a vast range of financial products, subject to the

client’s investment instructions, in consideration of a fee paid

to LTD based on the net value of the client’s assets on the first

day of each month. On a separate page for investment

instructions, clients authorized division of their investments

among four broad categories: Real estate, securities, fixed

assets, and other investments. The discretionary authorizations

specifically granted LTD

the full power to delegate the whole or any part of its

powers, duties, discretions and authority granted

hereunder to InverWorld, Inc.[,] a wholly owned

subsidiary of * * * [LTD], provided that * * * [LTD]

shall remain fully liable to the Client for any and all

actions of InverWorld, Inc.[,] undertaken pursuant to

authority delegated to it by * * * [LTD].
- 20 -

The discretionary authorizations granted LTD the power to

maintain or to transfer assets in omnibus accounts. In its early

Discretionary Authorizations, as well as in a brochure for

"selected investors who are not residents of the U.S.A.", and a

printed newsletter entitled "InverNews", LTD listed the San

Antonio office as its return address. 

Each client also granted a power of attorney to LTD,

allowing LTD to make investments in the name of the client, to

endorse for deposit and collection instruments payable to the

client, and to pay bills and fees of third parties on behalf of

the client. During LTD’s taxable years ended 1984 through 1986,

inclusive, the powers of attorney were notarized in Bexar County,

Texas. 

In some cases, the promoter assembled the account opening

documents signed by the client and sent them to San Antonio,

where they were countersigned in the name of LTD. Mr. Fahey

executed "some" discretionary authorizations on behalf of LTD in

the United States.

Once the account was opened, the promoter directed the

client to wire funds to a bank account opened in Texas in the

name of LTD. LTD called this bank account the client clearing

account or clearing account. Pursuant to its consulting

agreement with LTD, INC had the authority to invest the "cash,

securities, and other properties comprising the assets" of LTD's
- 21 -

clients as instructed by LTD. During each of the years in issue,

one or more employees or officers of INC had signatory authority

for LTD’s bank accounts.

INC maintained in San Antonio two types of files. The first

type was the client statement file, or client file, which

contained documents relating to client account activity. The

client statement file contained copies of LTD Statements of

Account, which identified only the client's LTD account number

and, if applicable, the client's third party institution account

number (e.g., the client's Shearson account number). 

Additionally, if applicable, the client statement files contained

copies of: (1) Third party institution statements of account,

which identified the client's name and the third party

institution client number; (2) LTD Cash Receipt forms, which

identified the client's name and LTD account number; (3) LTD

Check Requisition forms, which identified the client's name and

LTD account number; and (4) LTD Debit/Credit Memorandum forms,

which identified the client's name and LTD account number. 

The second type of file maintained by INC in San Antonio was

the client legal file, which contained documents relating to the

establishment of the client account itself. The client legal

file contained copies of: (1) The discretionary authorization

between LTD and the client, which included the client's

investment instructions and identified the client's name and LTD
- 22 -

account number; (2) the power of attorney, which identified the

client's name; (3) the client's Signature Card, signed by the

client, which identified the client's name, LTD account number,

and address; and (4) the client's passport, which identified the

client's name. Additionally, if applicable, the client legal

file contained correspondence, and, with corporate clients,

corporate documents such as certificates of incorporation and

minutes of corporate meetings. 

F. INC's Consulting Agreement With LTD

LTD and INC entered into an agreement dated "as of February

1, 1983" (the Agreement). Pursuant to the terms of the

Agreement, INC agreed to furnish LTD "with such factual

information, research reports and investment recommendations

relating to securities of issuers or other investments designated

by * * * [LTD]". INC agreed to furnish LTD with "such advice as

* * * [LTD] may reasonably request with respect to the relative

attractiveness of securities of issues or other investments

located in the United States." 

Paragraph 4 of the Agreement provides that, at the

discretion of LTD, INC 

will invest such cash, securities and other properties

comprising the assets of investment advisory clients of 

* * * [LTD] as * * * [LTD] shall instruct, in such manner as

* * * [LTD] shall instruct. In order to carry out such

instructions, * * * [INC] will have the authority for and in

the name of * * * [LTD]:

(a) to purchase, sell and deal in, on margin or
- 23 -

otherwise, listed and unlisted capital stock,

preorganization certificates and subscriptions, warrants,

bonds, notes, debentures whether subordinated, convertible

or otherwise, trust receipts, bankers’ acceptances,

government obligations and other obligations, choses in

action, instruments or evidences of indebtedness by

whomsoever issued, and other securities of whatever kind or

nature of any person, corporation, government or entity

whatsoever, whether readily marketable or not, and such

rights or options relating thereto including put and call

options written by * * * [INC] on behalf of * * * [LTD] or

by others (all such items being referred to herein as

securities), and to sell such securities short and cover

such sales;

(b) to purchase, hold, sell, transfer, exchange,

mortgage, pledge and otherwise act to acquire and dispose of

and exercise all rights, powers, privileges, and other

incidents of ownership or possession with respect to

securities held on behalf of * * * [LTD] or its clients,

with the objective of the preservation, protection and

increase in value thereof;

(c) to purchase securities for investment and to make

such representations to the seller of such securities, and

to other persons, that * * * [INC] may deem proper in such

circumstances, including the representation that such

securities are purchased by * * * [LTD] or its clients for

investment and not with a view to their sale or other

dispositions;

(d) to lend any of the properties which are from time 

to time held by * * * [LTD] on behalf of its clients; and

(e) to open, maintain, conduct and close accounts,

including margin accounts, with any broker, dealer or

investment concern at which * * * [LTD] maintains an account

on behalf of its clients with respect to the disposition and

application of monies or securities of * * * [LTD] or its

clients and from time to time held by such broker, dealer or

investment concern. 

Paragraph 5 of the Agreement provides that INC agrees

to maintain all books and records relating to the accounting

for transactions executed by * * * [INC] in accordance with

paragraph 4. Such accounting services shall include,

without limitation, the following:

(a) maintaining documentation and records relating to

the purchase, sale and settlement of portfolio securities,

including an investment ledger and a dealer ledger;
- 24 -

(b) monitoring, expediting and recording the

collection of all income due * * * [LTD] or its clients;

(c) summarizing, posting and recording all items of

cash receipts and disbursements, including reconciling all

bank accounts with the general books of account;

(d) maintaining a general ledger for the recording of

all transactions to the accounts of * * * [LTD] or its

clients; and

(e) preparing and issuing quarterly, semiannual and

annual reports to * * * [LTD] and its clients and providing

all information necessary for the preparation and filing of

any and all tax returns and reports to governmental agencies

by * * * [LTD] and its clients. 

Paragraph 6 of the Agreement provides:

In consideration for the performance by * * * [INC] of the

advisory and administrative Services pursuant to this

Agreement, there shall be paid to * * * [INC] an annual fee

of $114,000.00, payable monthly.

The foregoing annual fee shall be subject to yearly

amendment after review of the costs to * * * [INC] of

providing services hereunder. Such costs shall include that

portion of the salaries, wages and profit sharing of the

employees of * * * [INC] attributable to the performance of

services on behalf of * * * [INC] hereunder. 

Paragraph 8 of the Agreement provides:

* * * [INC] shall for all purposes be an independent

contractor and not an agent or employee of * * * [LTD], and

* * * [INC] shall have no authority to act for, represent,

bind or obligate * * * [LTD], any of its affiliates or any

account managed or advised by * * * [LTD]. 

The Agreement was executed, on behalf of LTD, by William L.

Bricker (a tax partner at Curtis, Mallet-Prevost, Colt & Mosle,

in New York, New York, who was secretary and tax counsel of LTD)

and, on behalf of INC, by Mr. Fahey. Letter agreements amended

INC's annual fee pursuant to the Agreement for the taxable years

ended June 30, 1984 through 1989. Such letter agreements were
- 25 -

normally signed by Mr. Bricker on behalf of LTD and then sent to

Mr. Fahey for his signature on behalf of INC. 

The letter agreement for the taxable year ended June 30,

1984, signed by Mr. Bricker and Mr. Fahey, was dated December 18,

1984. 

The letter agreement for the taxable year ended June 30,

1985, signed by Mr. Fahey but not Mr. Bricker, was dated July 1,

1984. The cover letter transmitting the letter agreement for the

taxable year ended June 30, 1985, was dated July 17, 1985. LTD

made 11 payments of $29,500, one each month, for a total of

$324,500 in fees during taxable year ended June 30, 1985. LTD

made an adjustment on June 30, 1985, paying an additional

$257,500 in fees for a final total of $582,000 for taxable year

ended June 30, 1985.

The letter agreement for taxable year ended June 30, 1986,

signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1,

1985". A letter from Steve Dooley, INC's controller, to Mr.

Bricker requesting that INC's fee for taxable year ended June 30,

1986, be adjusted to $945,000 was dated July 18, 1986. 

The letter agreement for taxable year ended June 30, 1987,

signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1,

1986". A letter dated August 5, 1987, telecopied from Mr. Dooley

to Mr. Bricker included a suggested annual fee of $1,281,000 and

a proposed profit and loss statement for INC's taxable year ended
- 26 -

June 30, 1987. In his response letter dated August 17, 1987, Mr.

Bricker asked Mr. Dooley "whether there may be some basis coming

up perhaps with a similar result but basing it upon a percentage

of assets." 

The letter agreement for taxable year ended June 30, 1988,

signed by Mr. Bricker and Mr. Fahey, was dated "As of August 1,

1987". 

The letter agreement for taxable year ended June 30, 1989,

signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1,

1988". 

The total fees paid by LTD to INC and the gross revenues

received by INC for each taxable year are set forth in the

following table:

 TYE Management fee Gross Revenues Percentage of INC’s 

June 30 from LTD to INC of INC Gross Revenues 

 1985 $582,000 $618,190 94.1%

 1986 945,000 953,583 99.1

 1987 1,281,000 1,395,545 91.8

 1988 1,440,000 1,532,579 94.0

 1989 1,830,000 1,909,563 95.8

G. Research

Pursuant to its Agreement with LTD, INC purchased, on behalf

of clients of LTD, certificates of deposit and term deposits from

banks located both within and without the United States. The

executive committee of the Inver Group established criteria,

relating to the bank’s size, equity, profitability, size of
- 27 -

deposits, assets and liabilities ratios, and standing with the

FDIC or FSLIC, to guide INC in selecting banks from which to

purchase certificates of deposit and term deposits. 

Pursuant to its Agreement with LTD, INC assembled and

maintained a document entitled Institution Standings, which

reflected financial information regarding financial institutions. 

Mr. Fahey contacted a list of banks throughout the United States

and obtained interest rates from each bank for 30-day, 60-day,

90-day, and 6-month placements of certificates of deposit and

term deposits. A list of the rates quoted by each bank was

telecopied, usually daily, to Mexico to inform promoters of the

current interest rates offered on the certificates of deposit and

term deposits. A promoter had no discretion to offer a client

higher interest rates than the rates reflected on the list but

did have the discretion to offer lower rates. 

H. Financial Accounting and Client Statements for LTD

Pursuant to its Agreement with LTD, INC provided the

bookkeeping for LTD. INC maintained all of LTD's records of

clients' transactions, which LTD called "lower level documents". 

Such records consisted of cash receipts, debit-credit memos, wire

transfers, and check requests reflecting every transaction for

every client. During the years in issue, LTD’s lower level

documents were maintained in the central filing system of INC in

San Antonio. 
- 28 -

INC produced in San Antonio daily proof sheets, which

summarized all client investment activities for a specified day. 

Proof sheets included a summary of client positions, a summary of

the certificates of deposit activity, and a summary of the "casa"

or house account. Proof sheets were based on individual

documentation of specific transactions as well as comparisons of

the specific transactional information to daily transaction

reports. Proof sheets reflected, for example, that a certain

dollar amount of client certificates of deposit had been bought

on a particular day. During the years in issue, the proof sheets

were maintained in INC's office in San Antonio although not in

the central filing system. 

INC produced in San Antonio journal vouchers, which were

summaries of the proof sheets, excluding references to client

activity. Journal vouchers related only to the financial

performance of LTD. INC used the journal vouchers to book income

or credit and debit items to LTD. Additionally, INC used the

journal vouchers to produce profit and loss statements and to

make entries into different general ledger accounts. 

INC generated monthly statements of LTD client account

activity. Each month, INC printed a client account statement

summarizing the client's activity for the month and the client's

holdings at a particular bank or investment fund. The client

statements, which listed only the client’s LTD account number,
- 29 -

were printed numerically by geographical region in Mexico. 

Generally, client statements were hand delivered by

promoters to clients. The client statements either were picked

up in San Antonio by a promoter from Mexico and taken to Mexico

or were taken by someone from San Antonio to Mexico. After mid1988, INC transferred the information in the client statements

onto a computer tape and transported the tape to Mexico City

where the statements were printed and sent to the promoters for

distribution to LTD’s clients. 

I. IRS Audit During Spring 1987

During the spring of 1987, the IRS notified INC that it

would be the subject of an audit. After INC became aware of the

upcoming audit, Mr. Dooley took LTD's general ledger to the

Cayman Islands. Additionally, LTD's journal vouchers were sent

to the Cayman Islands. The lower-level documents, however,

remained in San Antonio. Mr. Dooley took the general ledger to

the firm that LTD used to maintain its registration in the Cayman

Islands and discussed the logistics of having the firm maintain

the general ledger. 

Mr. Zollino decided, however, to begin maintaining LTD's

general ledger in Mexico. Journal vouchers, which were used to

make entries into LTD's general ledger, were still being produced

in San Antonio. Accordingly, David Rodriguez, an INC employee,

was sent to Mexico with the journal vouchers, which were entered
- 30 -

into the laptop computer that he took with him from San Antonio

to produce LTD's financial statements and general ledger.

The data and general ledger system for both INC and LTD were

needed in Mexico because Michael Graves, another INC employee,

and Mr. Rodriguez were producing consolidated financial

statements. While in Mexico, Mr. Graves was responsible for

insuring the integrity of the general ledger system and its

proper operation. When Mr. Graves and Mr. Rodriguez returned

from Mexico to San Antonio, they brought with them the computer

tape containing the client statements, the laptop computer

containing the general ledgers for LTD and INC, and a floppy disk

containing the general ledgers for INC and LTD.

J. The Transition to MultiValores

By the end of taxable year 1986, the Inver Group consisted

of seven operating companies. During early 1986, the operations

of InverMexico underwent a fundamental change, coinciding with

its registration as a public company on the Mexican stock

exchange. Such changes led to divisions within the Inver Group

and a reexamination of LTD's relation to InverMexico. 

During January 1987, Luis Garcia Blake, the principal and

owner of MultiValores S.A. de C.V. (MultiValores), a small,

Mexican stock brokerage firm, proposed to Mr. Zollino that LTD

join forces with MultiValores. The eight LTD partners who left

InverMexico were joined in the new Inver Group by six principals
- 31 -

of MultiValores who took interests in LTD. The combination with

MultiValores in 1987 brought changes in the financial and

operating controls of LTD and the Inver Group. Additionally,

during 1988, promoters in Mexico began working with "district

offices", which were consulting entities that served as

intermediaries between LTD and LTD’s clients. 

K. Accounting Firm Audit

LTD and INC engaged the services of the accounting firm of

Deloitte Haskins & Sells (Deloitte) in 1984. For each taxable

year ended June 30, 1984 through 1989, Deloitte performed a

separate audit of each company and a consolidated audit of LTD

and subsidiaries. 

L. LTD's Receipts

LTD's receipts during the years in issue fall into four

basic categories: (1) Management fees, (2) interest income, (3)

currency transactions, and (4) sales commissions and fees. The

total amounts of "gross receipts" and "direct costs" for each

category are discussed below. 

1. Management Fees

LTD charged its clients for management of their assets in

accordance with a "Schedule" or "Exhibit" attached to the

discretionary authorization. By signing the power of attorney,

each client authorized LTD to perform the following acts: (1)

"To issue orders and directions to any bank or trust company for

accounts held in name of the Client with respect to the
- 32 -

maintenance, disposition and application of its monies,

securities or commodities"; (2) "To open, maintain, conduct and

close accounts in the Client's name with any broker, dealer or

investment concern, to issue orders and directions to such

broker, dealer or investment concern for its account with respect

to the disposition and application of its monies, securities or

commodities from time to time held by such broker, dealer or

investment concern"; (3) "For the foregoing purpose to endorse

for deposit and collection all checks, certificates of deposit,

promissory notes, drafts, bills or exchange or other orders or

instruments for the payment of money payable to its order"; and

(4) "To pay bills and fees of third parties on behalf of the

Client for goods or services which the Client has received or

authorized." 

By signing the discretionary authorization, each client

authorized LTD to "manage the investment of the cash, securities

and other property of the Client as the Manager may hold from

time to time." Each client agreed that LTD,

in its sole discretion, shall invest the Assets in time

deposits, money market funds or interest bearing

investments or buy, sell (including short sales) and

trade commodities, commodity options, stocks, bonds,

options (including uncovered short positions in option

contracts or in the uncovering of any existing short

position in option contracts and any other securities

and/or contracts relating to the same on margin or

otherwise.

The discretionary authorization set forth LTD's compensation

system. The discretionary authorization stated: "The Client
- 33 -

shall pay the Manager as full compensation for the services

performed hereunder an annual fee based on the Manager's fee

schedule in effect from time to time; and, agrees that such

compensation may be deducted directly from the Assets by the

Manager and paid when due." The fee was fixed at 0.25, 0.50 or

1.00 percent of the value of the client's net assets placed with

LTD, depending upon the category of investment made by the

client. During 1986, LTD began using a revised Discretionary

Authorization in which LTD's fee was increased to 0.50 or 1.00

percent of the value of the client's net assets placed with LTD,

depending upon the category of investment made by the client. 

The gross receipts and direct costs (viz, commissions to

promoters) relating to LTD’s "Management Fees" for each taxable

year are as follows:

 TYE June 30 Gross Receipts Direct Costs

1985 $273,279 $33,852

1986 565,222 88,112

1987 655,223 51,978

1988 886,017 27,620

1989 1,119,259 (11,359)

2. Interest Income

a. U.S. Certificates of Deposit

and Bank Deposits 

All investments made by or on behalf of LTD's clients were

made in accordance with the terms of the discretionary

authorization and power of attorney. With regard to any funds

transferred to LTD's client clearing account for investment, the
- 34 -

client agreed that the investment was entirely at the client's

risk. The client agreed:

(a) "to indemnify and hold * * * [LTD] harmless from and to

pay * * * [LTD] promptly on demand any and all losses arising"

from an investment; 

(b) that "* * * [LTD] shall not be liable for any error of

judgment or for any loss suffered by the Client in connection

with the subject matter of the * * * [investment management]

Agreement";

 (c) that to the extent LTD acted as attorney in fact for

the client, it was for the client's "account and risk"; and

(d) that to the extent the client placed funds in excess of

FDIC or FSLIC insurance at any one bank (through LTD or

otherwise) "the client's investments may not be fully covered by

such insurance." 

LTD was also authorized by each client to pool that client’s

funds with other clients’ funds in order to obtain higher rates

of return. In authorizing LTD to pool funds, a client agreed

that "* * * [LTD] shall have the power to maintain, commingle, or

transfer Assets in omnibus accounts in the name of * * * [LTD] as

attorney in fact for the client and other clients having an

interest in the omnibus account." 

During 1986, the discretionary authorization signed by each

client was changed to include the provision that
- 35 -

The rate of return credited to the Client's account may

not reflect directly the rate of return earned by

specific investments; the Client's rate of return may

be net of expenses or may reflect the fact that 

* * * [LTD] may retain the benefit of special rates

attributable to the volume of investments controlled by

* * * [LTD].

For any amounts transferred by the client in excess of

$100,000, a certificate of deposit was purchased in the client's

own name in the face amount of $98,000. The maximum amount that

could be protected pursuant to the U.S. Government insurance

programs of the FDIC and FSLIC was $100,000. 

For amounts less than $100,000 and in increments of $10,000,

a client's funds were pooled with the funds of one or more other

LTD clients to purchase another $98,000 certificate of deposit. 

LTD called such a pooled fund the "IFF Fund". LTD represented to

its clients that IFF was a 28-day investment in a portfolio

comprising money market instruments and that IFF was created only

once a week. IFF, however, was merely a marketing name used to

differentiate between pooled and nonpooled purchases of

certificates of deposit. INC performed a daily accounting of

each client’s investments. If a client had more than $10,000 in

liquid funds in an LTD account as of the day once a week on which

LTD "created" the IFF Fund, INC placed the client’s funds in the

IFF Fund in $10,000 increments. 

By having the funds pooled, a higher rate of return was

earned on larger certificates of deposit. IFF paid interest at a

rate 20 basis points over the rate reported in the Wall Street
- 36 -

Journal's 30-day Jumbo CD report. Because the funds were pooled,

LTD purchased the certificate of deposit in its own name pursuant

to its authority to act as attorney in fact for each client in an

omnibus account. Initially, when the interest was remitted to

the client clearing account, a credit would be entered on each

client's account. Later, LTD changed its policy to credit each

client's account monthly, even though LTD had yet to receive any

interest income. 

Finally, for amounts less than $10,000, and in increments of

$100, a client’s funds were left on deposit in LTD’s client

clearing account, and the client’s account was credited with the

average rate paid by Frost Bank on the average balances for any

particular period. LTD called such account the "Money Market

Account" (MMA). LTD represented MMA to its clients as demand

deposits in a portfolio comprising money market instruments. MMA,

however, was merely a marketing name for the investment mechanism

that we have described supra. INC performed a daily accounting

of each client’s investments. If a client had funds of less than

$10,000 in an LTD account, INC placed the client’s funds into the

MMA in $100 increments. Any funds of a client below $100 were

not so invested. 

LTD derived three types of income from using the funds in

the client clearing account to invest in U.S. certificates of

deposit and U.S. bank deposits. The first type of income earned
- 37 -

6

The record reveals that the term "byte" was used also to

refer to what we call LTD’s "spread".

by LTD was called a "byte",6 which was the difference between the

interest obtained on client certificates of deposit and the

interest credited to client accounts. The second type of income

earned by LTD was called internally "basis" income. For certain

certificates of deposit purchased in the client’s name, LTD paid

clients a rate of return based upon a 365-day term of maturity

when such certificates actually had a 360-day term of maturity. 

LTD retained the difference, which it called "basis" income. The

third type of income earned by LTD was the "spread", which was

either the difference between (1) the interest obtained on

certificates of deposit purchased in LTD’s name and the interest

credited to client accounts for their IFF investments or (2) the

interest obtained on LTD's client clearing account and the

interest credited to client accounts for their MMA investments. 

Through the end of 1985, LTD credited its clients on the entire

amount of interest earned on IFF. 

During LTD’s taxable year ended June 30, 1985, the date on

which clients were paid interest for investments in certificates

of deposit was the date on which the interest was received by

LTD. With respect to the IFF and MMA, the date of payment of

interest was independent of the date interest was received by LTD

from the banks. 
- 38 -

b. Loans

During March 1986, LTD began making loans to clients. The

loans were collateralized by the clients' own certificates of

deposit. LTD verified the availability of funds and then

transferred the funds to the borrowers, usually by wire. LTD

lent the money to the client at the prime rate plus a maximum

amount of 2 percent. Accounting loans that were used to finance

purchases in other funds, however, were charged the interest rate

that the collateral was carrying, with the result that LTD did

not receive any income. Loans made to clients were not reflected

on the books of LTD but were recorded against a particular

client's account. In documents for a loan to its clients, LTD

listed the San Antonio office as its return address. 

c. Non-U.S. Certificates of Deposit

and Term Deposits 

During its taxable year ended 1989, LTD began offering its

clients the opportunity to place their funds in pooled

investments outside the United States. Such non-U.S.

certificates of deposit and non-U.S. term deposits program used

the same mechanics for investment as the pooled purchases of U.S.

certificates of deposit. LTD pooled clients’ funds and either

purchased non-U.S. certificates of deposit or made non-U.S. term

deposits in its own name, as attorney in fact, in accordance with

the clients' authorization provided to LTD in the discretionary

authorizations. Accordingly, the client, not LTD, bore the risk
- 39 -

of a bank failure or other loss of the investment. Because there

was no Government-sponsored insurance on the non-U.S.

investments, there was no purpose in dividing the purchases into

amounts of $100,000 or under. Consequently, all of the non-U.S.

investments were in amounts of $1 million or more, which paid

higher rates of return. 

LTD offered its clients investments in non-U.S. certificates

of deposit through products named "Eurodeposits", "InverCedes",

and "InverCede2". LTD offered its clients investments in nonU.S. term deposits through products named "Liquid Assets" and

"Term Deposits". LTD offered its clients a non-U.S. investment

named "Asset Management Account". The names denoted different

methods of timing of interest paid to the client, availability of

funds, deposit amounts, etc. Each such certificate of deposit or

term deposits, however, constituted a purchase from an omnibus

account in bank deposits outside the United States and Mexico. 

INC collected quotations of rates on certificates of deposit

and term deposits from various banks and telecopied to the

promoters term sheets listing all of the quoted rates. The term

sheets listed the top rate paid by each bank, and promoters

selling such investments negotiated a rate of return with

clients. Promoters could negotiate a lower, but not higher, rate

than the one listed on the term sheets. To the extent that a

bank might quote a higher rate of return because of the size of

the pooled deposit or the volume of transactions, LTD was
- 40 -

permitted by the discretionary authorization to retain a portion

of the enhanced return as its income. 

d. Pace Investments

LTD offered Pace investments (including one called Pace II)

to clients who had unused lines of credit with Mexican financial

institutions. Generally, such institutions would have

insufficient liquidity to allow clients to draw any further funds

on their lines of credit. LTD offered to its clients (who were

not necessarily the ones with unused lines of credit with Mexican

financial institutions) a stated rate of return on funds invested

for a fixed period of time. LTD deposited such funds with banks

in Mexico for a period of time coinciding with the maturity date

agreed upon with LTD's clients. LTD earned interest on the

deposited funds. The deposit was made with the stipulation that

the money be used to allow LTD’s client in Mexico to draw on its

formerly unused line of credit. 

The client, now able to draw upon its line of credit, paid

LTD a fee to complete the transaction. LTD derived income on the

difference between (1) the sum of the interest earned from the

Mexican bank and the fee earned from the client and (2) the

interest paid to its clients as their stated rate of return for

making a deposit with LTD. 

e. MMA II

MMA II was a "back-to-back" operation designed to take

advantage of a loophole in the Mexican tax law that lasted
- 41 -

7

We note that LTD had more investment products and investment

funds during the taxable years in issue than the parties have

addressed. 

approximately 18 months before it was closed. In a basic backto-back operation, a client’s funds deposited with LTD were used

as collateral for loans to a related client account. More

specifically, the mechanism took the following form: a client,

usually a Mexican corporation, placed U.S. dollars in LTD's MMA

II fund. The money was then lent to the owner of the client

corporation (MMA II notes). The dollars were exchanged by the

owner of the client corporation into pesos, and the pesos were

used to buy Mexican Treasury bills or "cetes", which were lent to

the client corporation. The Treasury bills were sold by the

client corporation and exchanged into dollars, and the dollars

were deposited into the client corporation's MMA II fund with

LTD. LTD charged its client corporations 1 percent more for the

loan than the interest rate paid on the MMA II notes. 

One of LTD’s "Direct Costs" of its interest income is an

item entitled "Interest Expense - Special Accounts". Such

expense represents the amount that LTD paid to LTD accounts such

as, inter alia,7 FEIM Fund, Currency Fund, and TVA, for their

positions in, inter alia, Eurodeposits, IFF, Pace Investments,

and InverCedes. 

The gross receipts and direct costs relating to LTD’s

"Interest Income" for each taxable year are as follows:
- 42 -

8

The parties stipulated total amounts that constitute direct

costs relating to LTD’s "Interest Income" category. The parties,

however, did not stipulate a breakdown of the direct costs, which

is necessary to our analysis, infra pp. 101-108, relating to

LTD’s interest income. We note that facts disclosed by the

Deloitte workpapers and the IRS revenue agent’s workpapers

provide the breakdown of the direct costs, which we set forth

herein and utilize in our analysis, infra pp. 101-108.

 TYE June 30 Gross Receipts Direct Costs

 1985 $751,058 $574,076

 1986 1,431,377 953,362

 1987 2,313,288 1,870,419

 1988 2,900,805 12,053,624

 1989 11,771,193 8,112,563

1We have deducted from the amount of direct costs the amount

of $4,521, which represents LTD's T-bill commission expense for

taxable year ended June 30, 1988, and which has been

recategorized in "Commissions - T-Bills." Accordingly, we

recalculate the direct costs for LTD's taxable year ended June

30, 1988, to be $2,053,624.

The breakdown of LTD’s "Direct Costs" for each taxable year is as

follows:8

TYE June 30 Direct Cost Amount

 1985 IFF + MMA 1$574,076

 1986 IFF 545,781

 MMA 407,581

 1987 IFF 472,938

 MMA 475,268

Commissions 726

Byte 887,634

Casa interest 33,853

 1988 IFF 690,978

MMA 949,087

 Byte 413,559

 1989 IFF 874,404

MMA 1,473,299

Asset Management Account 1,107

Eurodeposits 576,089

InverCedes 880,845

Liquid Assets 191,344

Term Deposits 4,626

Special Accounts 259,414
- 43 -

Pace 831,176

MMA II 2,903,946

Byte 116,313

1The record indicates that, in the direct costs for taxable

year ended June 30, 1985, the interest expenses consisted of IFF

and MMA interest expenses combined without distinction. 

3. Currency Exchange Transactions Income

LTD engaged in two types of currency exchange transactions. 

a. Currency Swaps

LTD arranged for its clients currency swaps, which were

contracts in dollar futures. In a currency swap, LTD and a

client entered into a contract in which LTD agreed to sell U.S.

dollars to the client for Mexican pesos at some future date. The

sale price for the dollars was determined in accordance with the

interest rate negotiated between LTD and the client. LTD's gross

receipts consisted of commissions that it received from Bank of

America and United States Trust for arranging the currency swaps. 

LTD’s direct costs were the commissions it paid out for arranging

the currency swaps. LTD stopped arranging currency swaps on

September 1, 1984. 

The gross receipts and direct costs relating to LTD’s

"Commissions on Foreign Exchange" are as follows:

TYE June 30 Gross Receipts Direct Costs

 1985 $54,386 $24,750

b. Currency Transactions

The second category of currency exchange transactions that

LTD engaged in was the sale and purchase of dollars on behalf of
- 44 -

clients. LTD engaged in four types of dollar transactions.

i. LTD arranged sales of dollars to a client in exchange

for pesos. The client contacted a promoter in Mexico, who quoted

an exchange rate for pesos to dollars. Once the client and the

promoter agreed on a rate, the promoter performed the exchange

operation from his office in Mexico. The client made pesos

available in Mexico to be exchanged, and the promoter documented

receipt of the pesos. The promoter then converted the pesos to

dollars at a Government-authorized Mexican exchange house. Once

the exchange was executed, the promoter directed that the dollars

be wired to San Antonio to be credited to the client's account. 

The transaction appeared as a credit on the client's monthly

statement. LTD's income derived from the difference between the

exchange rate obtained from the Mexican exchange house and the

rate quoted to and agreed to by the client. 

ii. LTD sold dollars from its own account to a client in

exchange for pesos. LTD transferred money, usually by wire, from

its Frost Bank Money Market account to the client's designated

financial institution. The transaction appeared as a debit from

LTD's Frost Bank account. 

iii. LTD arranged purchases of dollars from a client in

exchange for pesos. The client withdrew dollars from an LTD

account to exchange with pesos obtained by LTD. The transaction

appeared as a debit on the client's monthly statement. 
- 45 -

iv. LTD purchased dollars from a client in exchange for

pesos and deposited the dollars into LTD's own account. The

transaction appeared as a credit to LTD's Frost Bank account. 

Only transaction (i) involved the performance of personal

services in Mexico by a promoter. Specifically, in transaction

(i), the promoter handled the exchange with the Mexican brokerage

house. In transactions (ii), (iii), and (iv), the currency

transactions were handled in San Antonio with pesos being

deposited with or received from Mexican institutions. 

As of its taxable year ended June 30, 1989, LTD ceased to

conduct the currency transactions in its own name. The gross

receipts and direct costs relating to LTD’s income from "Currency

Transactions" for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1985 1$531,003 - 0 -

 1986 745,001 130,485

 1987 

 2434,867 16,125

 1988 

 3232,426 16,863

1The amount of gross receipts actually represents a net

balance amount with expenses already deducted. Neither revenue

agent's workpapers nor Deloitte's workpapers reveal the true

gross amount.

2The amount of gross receipts includes a check of $11,361

from the Guadalajara office representing its contribution to

profits.

3The amount of gross receipts includes a check of $16,426

from the Guadalajara office representing its contribution to

profits. 
- 46 -

4. Sales Commissions and Fees

a. Currency Fund

LTD created the "InverWorld Currency Fund" (Currency Fund)

to offer its clients access to the international currency market. 

Clients purchased units in the Currency Fund in $1,000 increments

with a $20,000 minimum. LTD deposited the funds in a foreign

bank, which decided in which currencies the funds that LTD placed

with it would be invested.

The client's yield on the fund was based on any increase in

the value per share over the term of the investment. No periodic

dividend or interest was paid. LTD's role was to act as

"Manager" of the Currency Fund. LTD and INC received clients’

funds, transferred them for management by the European banks, and

issued a periodic statement of the client's allocated share of

the Fund, using values determined by the fund managers in Europe. 

Funds that were "placed" by LTD’s clients in the Currency Fund

were not always placed by LTD in foreign institutions. During

the taxable year ended June 30, 1988, funds in the Currency Fund

were invested in cash accounts, money market accounts, and

investment accounts managed by Merrill Lynch and Lombard Odier &

Lir (Lombard). During the taxable year ended June 30, 1989,

funds in the Currency Fund were invested in Euro-deposits, Pace

investments, loans, and investment accounts managed by Bear

Stearns, Merrill Lynch, and Lombard. 
- 47 -

LTD charged its clients an initial placement cost of 3

percent of the funds placed in the Currency Fund. After the

first year LTD also charged an annual management fee of 1.00

percent of the value of the assets under management. The gross

receipts and direct costs relating to LTD’s "Commissions -

Currency Fund" for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1986 $116,604 $35,293

 1987 264,395 34,480

 1988 61,510 1,858

 1989 (6,509) - 0 -

b. FEIM Fund

The FEIM (an acronym for Fondo Estragegico De Inversion

Multiple) Fund was available to LTD clients during taxable years

ended June 30, 1986 through 1989. Similar in operation to the

Currency Fund, the FEIM Fund initially consisted of a basket of

GNMA, FNMA, and Federal Home Loan Mortgage Association mortgages. 

During taxable year ended June 30, 1988, client funds were

invested in the IFF. During taxable year ended June 30, 1989,

client funds were invested in money market accounts, Eurodeposits, Pace investments, loans, and investments managed by

Bear Stearns, Morgan Stanley, and Shearson. Clients sent signed

FEIM authorizations directly to INC. However, during the first 2

years, neither LTD nor INC had any role in the investment,

management, or valuation of the FEIM Fund assets. LTD marketed

the investment through its promoters in Mexico, and INC's only
- 48 -

role was to arrange for transfer of the client funds to Merrill

Lynch in Luxembourg and to include a monthly statement of the

client's allocated share of the fund value. Such valuation was

performed by the fund's managers at Merrill Lynch. By June 30,

1988, LTD had stopped sending funds overseas. In one of its

brochures describing the FEIM Fund, LTD listed the San Antonio

office as its return address.

LTD charged its clients an initial placement cost based on a

sliding scale of 4.00 percent to 0.25 percent, depending upon the

amount of funds placed in the FEIM Fund. After the first year

LTD also charged an annual management fee of 1.00 percent of the

value of the assets under management. The gross receipts and

direct costs relating to LTD’s "Commissions - FEIM Fund" for each

taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1986 $148,354 $44,500

 1987 71,716 11,587

 1988 (3,000) 116

 1989 4,951 - 0 -

c. Matric Fund

The Matric Fund (Matric) was an investment fund financing a

time-share resort in Puerto Vallarta, Mexico. Matric Corp.,

organized in the Cayman Islands, borrowed $10 million from LTD,

with Vallarta Internacional S.A., a Mexican corporation, as its

guarantor. LTD raised the $10 million by seeking commitments

from its clients to invest in Matric.
- 49 -

Clients investing in Matric signed an agency agreement with

LTD. Pursuant to the agency agreement, clients agreed to

indemnify LTD for any potential loss and to hold LTD responsible

for paying clients their share of the interest payments remitted

by Matric only if Matric paid LTD. 

LTD earned three types of income in connection with Matric

during the tax year ending June 30, 1989. The first type of

income that LTD earned was a 3-percent commission on the $10

million note, prorated for the 9 months that the note was

outstanding during taxable year ended June 30, 1989. The second

type of income that LTD earned was an initiation fee of 3-percent

of the $10 million note. The last type of income that LTD earned

was a consulting fee of $47,500. The gross receipts and direct

costs relating to LTD’s "Commissions [Matric]" for each taxable

year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1989 $575,000 - 0 -

d. Inversat Fund

LTD created Inversat REIT, a U.S. real estate investment

trust (REIT), to market to its clients. Clients purchased shares

in the REIT by placing funds with LTD, which in turn placed them

in its Inversat Fund. LTD then allocated the funds from the

Inversat Fund to the Inversat REIT, which purchased and managed

U.S. real estate. The Fund consisted of 5,000 shares, sold at

$1,000 each, with a minimum investment of $20,000. LTD sold all
- 50 -

2,774 shares in taxable year ended June 30, 1987. In one of its

brochures describing the Inversat Fund, LTD listed the San

Antonio office as its return address. 

LTD charged its clients an initial placement cost based on a

sliding scale of 3.50 to 0.25 percent, depending upon the amount

of funds placed in the Inversat Fund. After the first year LTD

also charged an annual management fee of 1.00 percent of the

value of the assets under management. The gross receipts and

direct costs relating to LTD’s "Commissions Inversat" for each

taxable year are as follows (it is noted that the Inversat Fund

management fee was not charged until taxable year ended June 30,

1988, and is reported under the general "Management Fees"

category):

TYE June 30 Gross Receipts Direct Costs

 1987 $86,762 $3,188

e. T.V. Answer

T.V. Answer (TVA) is an attachment for television sets that

uses radio signals to communicate with a minicomputer system. 

With the attachment, consumers can use their televisions to order

movies, to purchase goods, to retrieve information, to respond to

polls, and the like. 

TVA, Inc., was formed to exploit the commercial potential of

TVA. TVA, Inc., a Delaware corporation, was the wholly owned

subsidiary of Magus, Ltd., a Cayman Islands corporation, which

was in turn wholly owned by a trust. 
- 51 -

On July 7, 1986, in Monterrey, Mexico, LTD, entered into a

contract with the inventors of TVA and the investors in TVA, Inc.

(TVA partners). LTD agreed to obtain the funds necessary for the

commercial exploitation of TVA. To that end, LTD formulated a

prospectus and executed a marketing program to solicit venture

capital. The capital call was directed by Arnulfo Rodriguez,

head of MultiValores' investment banking unit in Monterrey. All

potential subscribers were contacted from the Monterrey office. 

Essentially, LTD raised $4,400,000 by purchasing units in the

trust for its clients' accounts.

For its expenses incurred in the capital call, LTD directed

INC to send Magus, Ltd., an invoice approximately every 6 months. 

LTD also instructed INC to pay TVA monthly an amount to cover its

development expenses. INC performed no other activities in the

capital call. 

In raising the funds for TVA, LTD received three types of

income. The first type of income was, pursuant to its contract

with the TVA partners, LTD’s right to commissions of 5 percent of

the total funds that it raised for TVA. The second type of

income was an administration fee from the TVA partners at a rate

of $5,000 per month. The third type of income was revenue that

LTD received by charging some clients who purchased units in the

trust a percentage commission. The gross receipts and direct

costs relating to LTD’s "Commissions TV Answer" and "TV Answer 

* * * [Administration] Fee" for each taxable year are as follows:
- 52 -

 TYE June 30 Commissions Administration Fee Direct Costs

1987 

 1$210,675 $15,000 $166,829

1988 50,607 60,000 800

1989 272,411 60,000 - 0 -

1We have deducted from the amount of commissions, $225,675,

the amount of $15,000, which represents LTD's administration fees

and which has been recategorized under "Administration Fee" for

taxable year ended June 30, 1987.

f. Client Incorporation and Trust Creation

LTD offered its clients the option of establishing offshore

corporations and trusts to hold their investments. Each client

signed a discretionary authorization granting LTD the power to

invest the funds held by the client’s corporation or trust. 

To establish an offshore corporation or trust for a client,

a promoter in Mexico completed a form listing the client’s choice

of jurisdiction, company name, and appointed directors. Such

form was then sent to INC, which passed the information to

outside lawyers or fiduciaries qualified to perform the necessary

paperwork in the chosen jurisdiction. 

The incorporation package completed by the lawyers or

fiduciaries was then returned to INC, which returned the package

to the client in Mexico. LTD's role, through the promoters, was

to provide the counseling on the structure and features of the

various incorporation options. Board of directors meetings for

at least two companies incorporated by LTD clients were held at

INC’s offices in San Antonio. LTD's clients used as their

addresses the address of INC’s offices in San Antonio. 
- 53 -

Clients establishing an offshore corporation or trust were

charged fees for the service directly against their accounts. 

LTD’s gross receipts derived from charging an "opening expense"

and an "annual expense". LTD’s direct costs were its payments to

the third party lawyers and fiduciaries. The gross receipts and

direct costs relating to LTD’s "Client Incorporation Fees" for

each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1986 $147,951 $18,286

 1987 363,014 126,855

 1988 290,518 161,037

 1989 404,286 227,697

g. Legal Advice Income

In an operating manual under the heading, "Legal Advise"

(sic) LTD described its services regarding the creation of

offshore corporations and trusts. The record reveals only that

LTD derived gross receipts relating to "Legal Advice Income". 

LTD’s direct costs were the commissions that it paid to promoters

for counseling clients regarding offshore corporations or trusts. 

The gross receipts and direct costs relating to LTD’s "Legal

Advice Income" for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1988 $8,630 $3,453

 1989 (328) 5,272

h. Letters of Credit

LTD issued, either directly or through a bank, letters of

credit to Mexican banks to secure loans for its clients. The
- 54 -

letters of credit were collateralized by certificates of deposit

that LTD had purchased with the client's funds. The gross

receipts and direct costs relating to LTD’s "Income from Letters

of Credit" for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1987 1$24,152 - 0 -

 1988 91,556 - 0 -

 1989 53,047 - 0 -

1We have recategorized under "Income from Letters of Credit"

for taxable year ended June 30, 1987, the amount of $24,152 of

gross receipts, which was originally categorized under "Other

Income".

i. Foreign Exchange Investments

LTD derived income from its foreign exchange investments. 

The gross receipts and direct costs relating to LTD’s "Income

Foreign Exchange Invest" are as follows:

TYE June 30 Gross Receipts Direct Costs

 1987 $8,425 - 0 -

j. Treasury Bills

LTD earned commissions from third parties on the sale of

U.S. Treasury bills to LTD’s clients. For taxable year ended

June 30, 1989, LTD’s commissions were from Merrill Lynch. LTD’s

direct costs were the commissions that it paid to promoters. The

gross receipts and direct costs relating to LTD’s "Commissions -

T-bills" for each taxable year are as follows:
- 55 -

TYE June 30 Gross Receipts Direct Costs

 1988 1$15,139 2$4,521

 1989 5,026 - 0 -

1 We have recategorized under "Commissions - T-bills" for

taxable year ended June 30, 1988, the amount of $15,139 of gross

receipts, which was originally categorized under "Other

Commission Income". 

2 We have recategorized under "Commissions - T-bills" for

taxable year ended June 30, 1988, the amount of $4,521 of direct

costs, which was originally categorized under "Interest Income". 

k. Wires and Checks

LTD charged its clients fees for transactions with third

party banks. For example, when a wire was sent or a foreign

check was received for deposit, the third party bank sometimes

charged a transaction fee to LTD, which passed through the fee to

the client, plus a transaction fee of its own. Depending on the

type of transaction, LTD added a $10 to $15 fee. The gross

receipts and direct costs relating to LTD’s "Wire and Check Fees"

for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1987 

1$6,866 - 0 -

 1988 13,274 - 0 -

 1989 26,360 - 0 -

1 We have recategorized under "Wire and Check Fees" for

taxable year ended June 30, 1987, the amount of $6,866 of gross

receipts, which was originally categorized under "Other Income".

l. Gold and Silver Futures

LTD maintained a gold and silver futures operations for its

clients. The gross receipts and direct costs relating to LTD’s
- 56 -

"Gold/Silver Income" for each taxable year are as follows:

TYE June 30 Gross Receipts Direct Costs

 1988 $14,110 $371

 1989 60,112 - 0 -

m. Project Income

LTD earned income on a research project for one of LTD's

clients. The gross receipts and direct costs relating to LTD’s

"Project Income" are as follows:

TYE June 30 Gross Receipts Direct Costs

 1988 $20,000 $4,135

n. Income From Investments

In the investment income category, LTD earned four items of

revenue. LTD reported gain on the sale of Currency Fund units. 

The funding account (also known as the client clearing account)

purchased Currency Fund units from clients during October and

November and subsequently sold them to the Currency Fund account

for a gain of $64,291.18. Additionally, LTD reported the gain on

the sale of FEIM Fund units. The funding account purchased FEIM

Fund units from clients and subsequently sold them to the FEIM

Fund account for a gain of $44,576.33. LTD had a loss on the

sale of stock in a concern known as TAMSA in the amount of

$11,275.35. Finally, LTD had a loss on an investment in Mexican

stocks in the amount of $83,061.23. The gross receipts and

direct costs relating to LTD’s "Income from Investments" are as
- 57 -

follows:

TYE June 30 Gross Receipts Direct Costs

 1988 $14,531 - 0 -

o. Other Commission Income/

Other Commissions and Fees

For taxable year ended June 30, 1988, the category "Other

Commission Income" included two types of revenue: $1,640 as

commissions on a "back-to-back" transaction and $776 as

commissions on the sale of stock. 

For taxable year ended June 30, 1989, the category "Other

Commissions and Fees" included two types of revenue: $24,633 as

additional commission fees that were charged to clients

considered to be of higher than normal risk, and $8,852 as

commissions on the sale of Inver stock. The gross receipts and

direct costs relating to LTD’s "Other Commission Income" and

"Other Commissions and Fees" for each taxable year are as

follows:

TYE June 30 Gross Receipts Direct Costs

 1988 

 1$2,416 - 0 - ("Other Commission Income")

 1989 33,485 8,345 ("Other Commissions and Fees")

1 We have deducted from the amount of gross receipts,

$17,555, the amount of $15,139, which represents LTD's

commissions from sales of Treasury bills and which has been

recategorized under "Commissions on the Sale of Treasury Bills"

for taxable year ended June 30, 1988.

p. Other Income

For taxable year ended June 30, 1985, the income items taken

as samples for Deloitte’s audit constituted "interest payments". 
- 58 -

For taxable year ended June 30, 1986, the Deloitte

workpapers provide no indication regarding the specific income

items taken as audit samples. 

For taxable year ended June 30, 1987, audit samples

included: (1) $24,152 for Letters of Credit, which has been

recategorized to "Letters of Credit", (2) $22,443 for Other

Income, (3) $6,866 for Wire and Check Fees, which has been

recategorized to "Wire and Check Fees", and (4) $2500 for

Commissions and Fees. 

For taxable year ended June 30, 1988, the four items taken

as samples for Deloitte's audit were: (1) Interest earned on the

sale of TVA, Inc. stock when the customer committed to buy the

stock but did not pay for it for several months, (2) commissions

on the sale of Lombard positions, (3) gain from the sale of

Arabian horses, and (4) fees from guaranteeing a line of credit

for a client. 

For taxable year ended June 30, 1989, the three items taken

as samples for Deloitte's audit were: (1) A reversal of excess

interest paid to a client in a prior year, (2) a reversal of

interest paid to a customer in error (with the end result of

canceling out the item initially listed as an interest expense),

and (3) revenue received for assisting a client in taking a

special tax election. The gross receipts and direct costs

relating to LTD’s "Other Income" for each taxable year are as

follows:
- 59 -

9

For calendar years 1984, 1985, and 1986, the parties

stipulated as revisions to the statutory notice of liability

amounts in docket No. 27090-90 on which LTD is potentially liable

for withholding tax. The parties, however, did not stipulate a

breakdown of the withholding amounts, which is necessary to our

analysis, infra pp. 160-184, relating to LTD’s withholding tax

liability. We note that a stipulated joint exhibit provides the

breakdown of the withholding amounts, which we set forth herein

and utilize in our analysis, infra pp. 160-184. We note that the

stipulated joint exhibit provides total amounts subject to

withholding tax different from the total amounts stipulated by

the parties.

TYE June 30 Gross Receipts Direct Costs

 1985 $49,297 - 0 -

 1986 20,735 - 0 -

 1987 124,943 - 0 -

 1988 83,442 - 0 -

 1989 108,250 96,692

1 We have deducted from the amount of gross receipts,

$55,961, the amount of $24,152, which represents LTD's letters of

credit fees, and which has been recategorized under "Fees for

Letters of Credit" for taxable year ended June 30, 1987.

Additionally, we have deducted from the amount of gross receipts

the amount of $6,866, which represents LTD's wire and check fees,

and which has been recategorized under "Wire and Check Fees" for

taxable year ended June 30, 1987. 

M. Amounts Subject to Withholding Tax

The total amounts in docket No. 27090-90 on which LTD is

potentially liable for withholding tax for each calendar year are

as follows:9 $481,692 for 1984; $1,168,498 for 1985; and

$1,135,757 for 1986. The breakdown of these amounts for each

calendar year is as follows:

 Calendar Type of Interest

 Year or Dividend Amount

 

 1984 IFF $333,137
- 60 -

10

For calendar years 1987, 1988, and 1989, the parties

stipulated as revisions to the statutory notice of liability

amounts in docket No. 3443-93 on which LTD is potentially liable

for withholding tax. The parties, however, did not stipulate a

breakdown of the withholding amounts, which is necessary to our

analysis, infra pp. 160-184, relating to LTD’s withholding tax

liability. We note that a stipulated joint exhibit provides the

breakdown of the withholding amounts, which we set forth herein

and utilize in our analysis, infra pp. 160-184. We note that the

stipulated joint exhibit provides total amounts subject to

withholding tax different from the total amounts stipulated by

the parties.

11

The statutory notice of liability included a dividend in the

amount of $500,000 that was subject to withholding tax for

calendar year 1987. The parties’ stipulated joint exhibit,

however, did not include any dividend amount as subject to

withholding tax for calendar year 1987.

At the commencement of trial, respondent moved to amend the

answers and to conform the pleadings to the proof in docket nos.

3441-93 and 3443-93. Respondent’s motions included an attempt to

introduce the $500,000 dividend as an amount subject to

(continued...)

 MMA 148,540

 1985 IFF 460,160

 MMA 205,186

 Dividend 503,147

 1986 IFF 593,093

 MMA 529,512

 Dividend 13,146

LTD declared a dividend of $516,263 on December 10, 1985,

and payable on December 20, 1985, to LTD shareholders according

to an established schedule. LTD paid $503,147 in calendar year

1985 and $13,146 in calendar year 1986. Both dividend payments,

however, were made during LTD’s taxable year ended June 30, 1986. 

The total amounts in docket No. 3443-93 on which LTD is

potentially liable for withholding tax for each calendar year are

as follows:10 $1,668,636 for 1987;11 $6,105,862 for 1988; and
- 61 -

11(...continued)

withholding tax for calendar year 1987. Respondent contended

that, because the dividend was in the statutory notice of

liability for calendar year 1987, it was still in issue. 

Petitioners objected to the dividend issue on the ground that it

was raised "only on the eve of trial." The Court denied the

motions as untimely. 

Respondent argues on brief that "the Court did not

specifically rule on petitioners’ objection" and that their

objection "should be overruled." We believe that implicit in our

denial of the motions to amend and to conform the pleadings to

the proof was a ruling that petitioners’ objection was sustained. 

Consequently, we find that the $500,000 dividend is not an amount

that is in issue for calendar year 1987 in the instant cases. 

For calendar year 1988, the parties’ stipulated joint

exhibit listed in brackets a dividend in the amount of $500,000

but did not include such amount in the total amount that was

subject to withholding tax. A dividend in the amount of $500,000

was not included in the statutory notice of liability for

calendar year 1988. Consequently, we find that the $500,000

amount listed as a dividend in the stipulated joint exhibit is

not an amount that is in issue for calendar year 1988 in the

instant cases.

$10,867,511 for 1989. The breakdown of these amounts is as

follows:

 Calendar Type of Interest

 Year or Dividend Amount

 1987 IFF $400,129

 MMA 587,014

 Byte 681,493 

 1988 IFF 1,115,904

 MMA 1,751,904

 InverCedes 220,178

 MMA II 3,017,875

 Byte 257,872

 1989 IFF 402,695

 MMA 800,214

 Asset Management Account 12,222

 Eurodeposits 1,579,147

 InverCedes 1,434,760

 InverCede2 92,305

 Liquid Assets 379,880
- 62 -

 Special Accounts 259,411

 Term Deposits 10,018

 Pace 5,895,859

 Byte 33,822

Respondent seeks to levy an identical withholding tax on INC

for calendar years 1987, 1988, and 1989. We find that the total

amounts on which INC is potentially subject to withholding tax

are the same as for LTD, viz, $1,668,636 for 1987; $6,105,862 for

1988; and $10,867,511 for 1989. The breakdown of the withholding

amounts is also the same as for LTD. See supra. 

III. OPINION

A. Whether LTD Was Engaged in Trade

or Business Within the United States

The first issue we must decide is whether LTD was engaged in

trade or business within the United States pursuant to section

864(b). If we decide that LTD was engaged in trade or business

within the United States, then we must decide the character and

the source of each item of LTD's income and whether each such

item was effectively connected with the conduct of such trade or

business pursuant to section 864(c).

Foreign corporations operating in the United States are

subject to two U.S. taxation regimes. Under the first regime, a

foreign corporation engaged in trade or business within the

United States during the taxable year is taxable on its income

which is effectively connected with the conduct of such trade or

business within the United States (effectively connected income). 
- 63 -

Sec. 882(a)(1). Effectively connected income can originate from

sources within the United States, sec. 864(c)(2) and (3), or from

sources without the United States, sec. 864(c)(4), and is taxed

at the same rates that apply to a U.S. corporation under section

11. Under the second regime, a flat tax of 30 percent is imposed

on a foreign corporation’s gross income from "interest (other

than original issue discount as defined in section 1273),

dividends, rents, salaries, wages, premiums, annuities,

compensations, remunerations, emoluments, and other fixed or

determinable annual or periodical gains, profits, and income",

but only to the extent the amount is received from sources within

the United States and is not effectively connected with the

conduct of trade or business by such corporation within the

United States. Sec. 881(a). A foreign corporation is not

subject to tax on its income which is not effectively connected

with its conduct of trade or business within the United States

and which is received from sources without the United States. 

Id. In sum, if LTD is engaged in trade or business within the

United States, income items effectively connected with LTD's

trade or business, including items from sources without the

United States as described in section 864(c)(4), are taxed

pursuant to section 882(a)(1) at regular corporate rates; income

items not effectively connected with any trade or business

conducted by LTD within the United States, if sourced from within
- 64 -

the United States, are taxed at 30 percent pursuant to section

881(a), but if sourced from without the United States, are not

subject to U.S. taxation.

1. Background

For purposes of section 882(a)(1), the phrase "trade or

business within the United States" generally includes "the

performance of personal services within the United States at any

time within the taxable year". Sec. 864(b). We believe that

section 1.864-4(c)(5)(i), Income Tax Regs., which determines

whether a foreign corporation is "engaged in the active conduct

of a banking, financing, or similar business in the United

States", provides a useful framework in the instant case for

analyzing whether LTD engaged in trade or business within the

United States. For, if LTD engaged in the active conduct of a

banking, financing, or similar business in the United States,

then, a fortiori, LTD was engaged in trade or business within the

United States.

2. Section 1.864-4(c)(5)(i), Income Tax Regs., Engaged in

a Banking Business Test

Section 1.864-4(c)(5)(i), Income Tax Regs., provides that a

foreign corporation is considered 

to be engaged in the active conduct of a banking,

financing, or similar business in the United States if

at some time during the taxable year the taxpayer is

engaged in business in the United States and the

activities of such business consist of any one or more

of the following activities carried on, in whole or in
- 65 -

12

Additionally, LTD engaged in creating and operating a U.S.

(continued...)

part, in the United States in transactions with persons

situated within or without the United States: 

(a) Receiving deposits of funds from the public,

(b) Making personal, mortgage, industrial, or other 

loans to the public,

(c) Purchasing, selling, discounting, or negotiating 

for the public on a regular basis, notes, drafts, checks, 

bills of exchange, acceptances, or other evidences of 

indebtedness,

(d) Issuing letters of credit to the public and 

negotiating drafts drawn thereunder

(e) Providing trust services for the public, or

(f) Financing foreign exchange transactions for the 

public. 

LTD engaged in four of the six activities listed in the

regulation. LTD engaged in "Receiving deposits of funds from the

public" by receiving deposits of funds from its clients into its

client clearing account. LTD engaged in "Making personal * * *

loans to the public" by making loans to its clients. LTD engaged

in "Purchasing * * * [and] selling * * * for the public on a

regular basis * * * evidences of indebtedness" by purchasing and

selling for its clients on a regular basis: (1) Certificates of

deposit and (2) interests in such certificates of deposit. LTD

engaged in "Issuing letters of credit to the public". Finally,

LTD engaged in "Financing foreign exchange transactions for the

public" by effecting currency exchange transactions for the

public with Mexican banks. LTD engaged in all of the above

activities,12 in whole or in part, in the United States in
- 66 -

12(...continued)

real estate investment trust, creating offshore corporations and

trusts, purchasing U.S. Treasury bills, and trading in gold and

silver futures. 

transactions with persons situated within or without the United

States. Accordingly, we conclude that LTD performed the

activities required for a foreign corporation to be considered "a

banking, financing, or similar business in the United States"

within the meaning of section 1.864-4(c)(5)(i), Income Tax Regs. 

In addition to the listed activities, however, section

1.864-4(c)(5)(i), Income Tax Regs., requires that the foreign

corporation "at some time during the taxable year" be "engaged in

business in the United States". Petitioners argue that certain

trading activities performed by LTD are excludable from the

determination of whether LTD is engaged in "trade or business

within the United States" pursuant to section 864(b). 

Petitioners argue that pursuant to section 864(b)(2)(A)(i) and

(ii), LTD’s trading in stocks or securities are excluded from the

determination of whether LTD is engaged in "trade or business

within the United States". The activity of "Trading in stocks or

securities through a resident broker, commission agent,

custodian, or other independent agent" is excluded from the

definition of "trade or business within the United States". Sec.

864(b)(2)(A)(i). The exclusion applies, however, "only if, at no

time during the taxable year, the taxpayer has an office or other

fixed place of business in the United States through which or by
- 67 -

the direction of which the transactions in stocks or securities 

* * * are effected." Sec. 864(b)(2)(C). 

Petitioners argue that all of their activities are eligible

to be excluded because the exclusion extends broadly to persons

trading for their own account or for the account of others and

because the agents through which trading is effected need not be

independent in order to qualify under section 864(b)(2)(A)(i). 

We disagree. The exclusion requires that the trading in stocks

or securities be effected "through a resident broker, commission

agent, custodian, or other independent agent." Sec.

864(b)(2)(A)(i). We conclude that the phrase means that

excludable trading in stocks or securities must be effected

through independent agents and that LTD's trading through INC was

not so effected. 

To qualify for the exclusion, trading in stocks or

securities must be effected by the agents referred to in section

864(b)(2)(A)(i). The fourth relationship to which that section

refers is an "other independent agent." We believe that the

phrase "other independent agent" serves to modify the language

preceding it. In other words, the resident broker, commission

agent, or custodian must each be an "independent agent." 

Consequently, we conclude that section 864(b)(2)(A)(i) requires

that the trading in stocks or securities be effected through an

independent resident broker, an independent commission agent, an
- 68 -

13

Sec. 1.864-2(c)(2)(i), Income Tax Regs., defines a security

for purposes of par. (c) of sec. 1.864-2, Income Tax Regs., as: 

"any note, bond, debenture, or other evidence of indebtedness, or

any evidence of an interest in or right to subscribe to or

purchase any of the foregoing."

independent custodian, or some other independent agent.

The record shows that LTD engaged in the trading of

securities through a resident broker by virtue of its

certificates of deposit operation.13 The Inver Group established

criteria to guide INC in selecting the financial institutions

from which INC could purchase certificates of deposit for LTD and

LTD’s clients. INC researched the financial institutions using

the Inver Group’s criteria and obtained interest rate quotes. 

Upon receipt of funds and an order to invest, INC placed the

funds in certificates of deposit in either the client’s or LTD’s

name. We conclude that, by engaging in such activities, LTD

engaged in trading in securities through its agent INC.

Section 1.864-7, Income Tax Regs., provides a definition of

"independent agent" for purposes of determining whether a foreign

corporation has "an office or other fixed place of business

within the United States" within the meaning of section

864(c)(4)(B) and the regulations thereunder. The phrase "office

or other fixed place of business in the United States" also

appears in section 864(b)(2)(C). Although the regulation does

not expressly provide that it is to apply for purposes of section
- 69 -

864(b)(2)(A)(i), we believe that the regulation furnishes a

proper framework for interpreting the term "independent agent"

for purposes of section 864(b)(2)(A)(i). 

Section 1.864-7(d)(3)(i), Income Tax Regs., provides: 

For purposes of this paragraph * * * [of the

regulation], the term “independent agent” means a general

commission agent, broker, or other agent of an independent

status acting in the ordinary course of his business in that

capacity. Thus, for example, an agent who, in pursuance of

his usual trade or business, and for compensation, sells

goods or merchandise consigned or entrusted to his

possession, management, and control for that purpose by or

for the owner of such goods or merchandise is an independent

agent.

Section 1.864-7(d)(3)(ii), Income Tax Regs., however, provides: 

The determination of whether an agent is an independent

agent for purposes of this paragraph shall be made without

regard to facts indicating that either the agent or the

principal owns or controls directly or indirectly the other

or that a third person or persons own or control directly or

indirectly both. For example, a wholly owned domestic

subsidiary corporation of a foreign corporation which acts

as an agent for the foreign parent corporation may be

treated as acting in the capacity of independent agent for

the foreign parent corporation. The facts and circumstances

of a specific case shall determine whether the agent, while

acting for his principal, is acting in pursuance of his

usual trade or business and in such manner as to constitute

him an independent agent in his relations with the

nonresident alien individual or foreign corporation.

Finally, section 1.864-7(d)(3)(iii), Income Tax Regs., provides:

Where an agent who is otherwise an independent agent

within the meaning of subdivision (i) of this subparagraph

acts in such capacity exclusively, or almost exclusively,

for one principal who is a nonresident alien individual or a

foreign corporation, the facts and circumstances of a

particular case shall be taken into account in determining

whether the agent, while acting in that capacity, may be

classified as an independent agent.
- 70 -

Applying the foregoing regulations to the facts of the

instant case, we note that, although INC was, either directly or

indirectly, a wholly owned subsidiary of LTD, section 1.864-

7(d)(3)(ii), Income Tax Regs., requires the determination of

whether INC is an independent agent to be made without regard to

the fact that LTD "owns or controls directly or indirectly" INC. 

Accordingly, we disregard the fact that LTD owned, either

directly or indirectly, all of INC in our consideration of

whether INC was "a general commission agent, broker, or other

agent of an independent status acting in the ordinary course of *

* * [its] business in that capacity." Sec. 1.864-7(d)(3)(i),

Income Tax Regs. 

INC was an investment adviser registered with the SEC. 

INC’s business, in part, was that of a broker of certificates of

deposit. Guided by Inver Group’s criteria, INC researched and

selected the financial institutions from which it purchased

certificates of deposit for LTD and LTD’s clients. INC performed

brokerage services for LTD and LTD’s clients. INC, however,

acted almost exclusively for one principal, i.e., LTD, which is a

foreign corporation. Consequently, we conclude that INC is an

"exclusive" agent within the meaning of section 1.864-

7(d)(3)(iii), Income Tax Regs., supra. Accordingly, we must take

into account the facts and circumstances "in determining whether

the agent, while acting in that capacity, may be classified as an

independent agent." Sec. 1.864-7(d)(3)(iii), Income Tax Regs. 
- 71 -

The record shows that INC had few clients other than LTD and

LTD’s clients. The services that INC performed were almost

exclusively for LTD, such as bookkeeping, effecting trades in

securities, generating client statements, and effecting currency

exchange transactions. The percentage of INC’s gross revenues

derived from LTD were as follows: 94.1 percent in 1985, 99.1

percent in 1986, 91.8 percent in 1987, 94.0 percent in 1988, and

95.8 percent in 1989. Moreover, the record does not establish

that INC marketed its services to clients on its own. Based on

the record in the instant case, we conclude that INC was not an

"independent agent" within the meaning of section 1.864-7(d)(3),

Income Tax Regs. Consequently, we hold that LTD did not engage

in trading in stocks or securities through an independent agent

within the meaning of section 864(b)(2)(A)(i).

Additionally, section 864(b)(2)(A)(i) applies "only if, at

no time during the taxable year, the taxpayer has an office or

other fixed place of business in the United States through which

or by the direction of which the transactions in stocks or

securities * * * are effected." Sec. 864(b)(2)(C); see sec.

1.864-2(c)(1), Income Tax Regs. Both parties, presuming that

INC's San Antonio office was an office through which or by the

direction of which LTD’s transactions in stocks or securities

were effected, focus their arguments on whether INC's San Antonio

office can be attributed to LTD. Petitioners seek to apply
- 72 -

14

Sec. 1.864-7(d)(1)(i), Income Tax Regs., provides: 

In determining whether a nonresident alien

individual or a foreign corporation has an office or

other fixed place of business, the office or other

fixed place of business of an agent who is not an

independent agent, as defined in subparagraph (3) of

this paragraph, shall be disregarded unless such agent

(a) has the authority to negotiate and conclude

contracts in the name of the nonresident alien

individual or foreign corporation, and regularly

exercises that authority, or (b) has a stock of

merchandise belonging to the nonresident alien

individual or foreign corporation from which orders are

regularly * * * [filled] on behalf of such alien

individual or foreign corporation * * *.

section 1.864-7(d)(1)(i), Income Tax Regs.14 Accordingly,

petitioners contend that INC's office in San Antonio should not

be considered LTD's "office or other fixed place of business" in

the United States because INC did not have the authority to

negotiate or to conclude contracts on behalf of LTD. Petitioners

argue that, "Even if INC is deemed to be a dependent agent, by

its agreement with LTD it had 'no authority to act for,

represent, bind or obligate * * * [LTD]' without first obtaining

LTD’s consent and in fact it did not do so without first

obtaining the consent of LTD." 

Respondent also seeks to apply section 1.864-7(d)(1)(i),

Income Tax Regs., contending that INC's San Antonio office should

be considered LTD's office for the purpose of applying the

regulation.

Section 1.864-7(d)(1)(i), Income Tax Regs., provides that

the office of an agent who is not an independent agent will be

disregarded in the determination of whether a taxpayer has "an
- 73 -

office or other fixed place of business in the United States"

unless the agent performs specified duties. The physical

location of the office of an agent, however, is only one factor

of five provided in section 1.864-7, Income Tax Regs., to be

considered in such a determination. Section 1.864-7(d)(1)(i),

Income Tax Regs., expressly provides that it applies for purposes

of section 864(c)(4)(B) and section 864(c)(4)(B)(iii), and the

regulations thereunder, but it does not expressly provide that it

is to apply for purposes of section 864(b)(2)(C). Nonetheless,

because both parties argue their respective positions based on

section 1.864-7(d)(1)(i), Income Tax Regs., and because those

regulations construe the phrase "office or other fixed place of

business in the United States", which is also found in section

864(b)(2)(C), we use those regulations in the instant case as a

framework to decide whether LTD has "an office or other fixed

place of business in the United States" for purposes of section

864(b)(2)(C).

Section 1.864-7(a)(2), Income Tax Regs., provides that, in

determining whether a taxpayer has "an office or other fixed

place of business in the United States" within the meaning of the

statute, "due regard shall be given to the facts and

circumstances of each case, particularly to the nature of the

taxpayer's trade or business and the physical facilities actually

required by the taxpayer in the ordinary course of the conduct of

his trade or business." The factors to consider include: (1)
- 74 -

Fixed facilities, (2) management activity, (3) agent activity,

(4) employee activity, and (5) office or other fixed place of

business of a related person. Sec. 1.864-7, Income Tax Regs. We

examine each of the factors in turn. 

(1) Fixed facilities. The general rule is that "an office

or other fixed place of business is a fixed facility, that is, a

place, site, structure, or other similar facility, through which

a nonresident alien individual or a foreign corporation engages

in a trade or business." Sec. 1.864-7(b)(1), Income Tax Regs. 

"A fixed facility may be considered an office or other fixed

place of business whether or not the facility is continuously

used by a nonresident alien individual or foreign corporation." 

Id. Furthermore:

A nonresident alien individual or a foreign corporation

shall not be considered to have an office or other fixed

place of business merely because such alien individual or

foreign corporation uses another person’s office or other

fixed place of business, whether or not the office or other

fixed place of business of a related person, through which

to transact a trade or business, if the trade or business

activities of the alien individual or foreign corporation in

that office or other fixed place of business are relatively

sporadic or infrequent, taking into account the overall

needs and conduct of that trade or business. * * * [Sec.

1.864-7(b)(2), Income Tax Regs.] 

(2) Management activity. The regulations take into account

where the "top management" decision-making takes place and where

"the day-to-day trade or business of the foreign corporation”

occurs. Sec. 1.864-7(c), Income Tax Regs.

(3) Agent activity. The regulations provide:
- 75 -

the office or other fixed place of business of an agent

who is not an independent agent, as defined in

subparagraph (3) of this paragraph, shall be

disregarded unless such agent (a) has the authority to

negotiate and conclude contracts in the name of the

nonresident alien individual or foreign corporation,

and regularly exercises that authority, or (b) has a

stock of merchandise belonging to the nonresident alien

individual or foreign corporation from which orders are

regularly * * * [filled] on behalf of such alien

individual or foreign corporation. * * * [Sec. 1.864-

7(d)(1)(i), Income Tax Regs.]

The regulations also provide:

an agent shall be considered regularly to exercise

authority to negotiate and conclude contracts or

regularly to fill orders on behalf of his foreign

principal only if the authority is exercised, or the

orders are filled, with some frequency over a

continuous period of time. This determination shall be

made on the basis of the facts and circumstances in

each case, taking into account the nature of the

business of the principal; but, in all cases, the

frequency and continuity tests are to be applied

conjunctively. Regularity shall not be evidenced by

occasional or incidental activity. An agent shall not

be considered regularly to negotiate and conclude

contracts on behalf of its foreign principal if the

agent’s authority to negotiate and conclude contracts

is limited only to unusual cases or such authority must

be separately secured by the agent from his principal

with respect to each transaction effected. * * * [Sec.

1.864-7(d)(1)(ii), Income Tax Regs.]

(4) Employee activity. The regulations provide:

Ordinarily, an employee of a nonresident alien

individual or a foreign corporation shall be treated as

a dependent agent to whom the rules of paragraph (d)(1)

of this section apply if such employer does not in and

of itself have a fixed facility (as defined by

paragraph (b) of this section) in the United States or

outside the United States, as the case may be. 

However, where the employee, in the ordinary course of

his duties, carries on the trade or business of his

employer in or through a fixed facility of such

employer which is regularly used by the employee in the

course of carrying out such duties, such fixed facility

shall be considered the office or other fixed place of
- 76 -

business of the employer, irrespective of the rules of

paragraph (d)(1) of this section. * * * [Sec. 1.864-

7(e), Income Tax Regs.]

(5) Office or other fixed place of business of a related

person. The regulations provide:

The fact that a nonresident alien individual or a

foreign corporation is related in some manner to

another person who has an office or other fixed place

of business shall not of itself mean that such office

or other fixed place of business of the other person is

the office or other fixed place of business of the

nonresident alien individual or foreign corporation. 

Thus, for example, the U.S. office of foreign

corporation M, a wholly owned subsidiary corporation of

foreign corporation N, shall not be considered the

office or other fixed place of business of N unless the

facts and circumstances show that N is engaged in trade

or business in the United States through that office or

other fixed place of business. However, see paragraph

(b)(2) of this section * * * [regarding relatively

sporadic or infrequent activities]. * * * [Sec. 1.864-

7(f), Income Tax Regs.]

With the foregoing factors in mind, we consider the facts

and circumstances of the instant case. The record establishes

that LTD had a fixed facility in the sense that it used the San

Antonio office to engage in its trade or business. The San

Antonio office, upon receipt of investment instructions from the

promoters, effected the transactions in question. The San

Antonio office’s address was used as LTD’s return address on,

inter alia, LTD’s early discretionary authorizations, a FEIM Fund

brochure, an Inversat Fund brochure, a brochure for "selected

investors who are not residents of the U.S.A.", a printed

newsletter entitled "InverNews", and in documents for a loan to a
- 77 -

client. The San Antonio office was the place where LTD client

files were maintained. LTD's use of the San Antonio office for

both its operations and as a return address was so extensive that

we believe, taking into account the overall needs and conduct of

LTD’s trade or business, that LTD’s use of the San Antonio office

cannot be described as falling under the "relatively sporadic or

infrequent" exception. Sec. 1.864-7(b)(2), Income Tax Regs. 

Moreover, LTD has not shown that it maintained any other fixed

facility through which it engaged in its activities. 

Accordingly, we hold that the San Antonio office was LTD’s fixed

facility in the United States during the years in issue for

purposes of section 1.864-7(b), Income Tax Regs. 

As to the location of the management activity, section

1.864-7(c), Income Tax Regs., and related examples, section

1.864-7(g), Examples (1)-(3), Income Tax Regs., take into account

not only where the "top management decisions" are made but also

where "the day-to-day trade or business of the foreign

corporation" is conducted. LTD’s day-to-day trade or business

was to provide its Mexican clients with access to non-Mexican

financial markets. That day-to-day trade or business was

conducted in the San Antonio office, where the clients’ files

were located, investment instructions were received and carried

out, client statements were produced, and LTD’s daily proof

sheets and journal vouchers were produced. 
- 78 -

15

A dependent agent is equated in the regulations with "an

agent who is not an independent agent, as defined in subparagraph

(3) of this paragraph". Sec. 1.864-7(d)(1)(i), Income Tax Regs.

As we have concluded, supra p. 70, that INC is not an

"independent agent" within the meaning of section 1.864-7(d)(3),

Income Tax Regs., we next examine whether INC is a dependent

agent15 which "has the authority to negotiate and conclude

contracts in the name of the nonresident alien individual or

foreign corporation, and regularly exercises that authority"

within the meaning of section 1.864-7(d)(1)(i), Income Tax Regs. 

Petitioners argue that, if INC is deemed to be a dependent agent,

INC is not to be considered regularly to "negotiate and conclude

contracts" on behalf of LTD because INC had, pursuant to its

agreement with LTD, no authority to act for, represent, bind or

obligate LTD "without first obtaining LTD’s consent" and that INC

did not act for, represent, bind, or obligate LTD "without first

obtaining the consent of LTD." Additionally, petitioners contend

that INC did not have the authority to negotiate or to conclude

contracts on LTD’s behalf.

In deciding whether INC had that type of authority, we

examine the agreement governing the relationship between INC and

LTD (Agreement) and the entire record before us. Petitioners

rely upon paragraph 8 of the Agreement, which provides that INC

"shall for all purposes be an independent contractor and not an

agent or employee of * * * [LTD], and * * * [INC] shall have no
- 79 -

authority to act for, represent, bind or obligate * * * [LTD],

any of its affiliates or any account managed or advised by * * *

[LTD]." Paragraph 4 of the Agreement, however, provides detailed

authority for INC to act on LTD’s behalf:

* * * [INC] will invest such cash, securities and other

properties comprising the assets of investment advisory

clients of * * * * [LTD] as * * * [LTD] shall instruct, in

such manner as * * * [LTD] shall instruct. In order to

carry out such instructions, * * * [INC] will have the

authority for and in the name of * * * [LTD]:

(a) to purchase, sell and deal in * * * instruments or

evidences of indebtedness by whomsoever issued * * *;

(b) to purchase, hold, sell, transfer, exchange,

mortgage, pledge and otherwise act to acquire and dispose of

and exercise all rights, powers, privileges, and other

incidents of ownership or possession with respect to

securities held on behalf of * * * [LTD] or its clients,

with the objective of the preservation, protection and

increase in value thereof; 

(c) to purchase securities for investment and to make

such representations to the seller of such securities, and

to other persons, that * * * [INC] may deem proper in such

circumstances, including the representation that such

securities are purchased by * * * [LTD] or its clients for

investment and not with a view to their sale or other

disposition;

(d) to lend any of the properties which are from time

to time held by * * * [LTD] on behalf of its clients; and

(e) to open, maintain, conduct and close accounts * * *

with any broker, dealer or investment concern at which 

* * * [LTD] maintains an account on behalf of its clients 

with respect to the disposition and application of monies or

securities of * * * [LTD] or its clients and from time to 

time held by such broker, dealer or investment concern.

Thus, paragraph 8 and paragraph 4 contain seemingly inconsistent

terms. 

As we interpret the Agreement, however, the specific vesting

of authority in INC upon the issuance of instructions from LTD,

pursuant to paragraph 4 of the Agreement, overrides the provision
- 80 -

in paragraph 8 that INC "shall have no authority to act for,

represent, bind or obligate" LTD as to the matters covered by the

instructions. We therefore conclude that INC had “the authority

for and in the name of LTD” to carry out the acts specified in

the Agreement pursuant to LTD’s instructions, including, inter

alia, purchasing, selling, and dealing in instruments or

evidences of indebtedness by whomsoever issued. INC alone

performed the purchase, sale, and redemption of the instruments

and evidences of indebtedness. Accordingly, we conclude that,

pursuant to its Agreement with LTD, INC had "the authority to

negotiate and conclude contracts" in the name of the foreign

corporation LTD within the meaning of section 1.864-7(d)(1)(i),

Income Tax Regs.

Nonetheless, we must consider whether INC "regularly

exercised" its authority to negotiate and to conclude contracts

in LTD’s name, whether such authority was limited to unusual

cases, and whether such authority was separately secured for each

transaction effected within the meaning of section 1.864-

7(d)(1)(ii), Income Tax Regs. For LTD’s certificates of deposit

and term deposits operation, the executive committee of Inver

Group established criteria (relating to the bank’s size, equity,

profitability, size of deposits, assets and liabilities ratios,

and standing with the FDIC or FSLIC) to guide INC in selecting

banks from which to purchase certificates of deposit and term
- 81 -

deposits. Mr. Fahey testified that he compiled a list of banks

that Mr. Zollino approved.

Pursuant to its Agreement with LTD, INC assembled and

maintained a document entitled Institution Standings, which

reflected the financial information of financial institutions

that met the Inver Group’s criteria. Mr. Fahey contacted banks

throughout the United States that were on the approved list and

obtained interest rates from each bank for 30-day, 60-day, 90-

day, and 6-month placements of certificates of deposit and term

deposits. A list of the rates quoted by each bank was

telecopied, usually daily, to Mexico to inform promoters of the

current interest rates offered on certificates of deposit and

term deposits. Mr. Fahey testified that he "got approval of the

banks that were on * * * [the list telecopied to promoters], but

not approval on a daily basis for the rates that I quoted on

there." Promoters sold the certificates of deposit or term

deposits (or interests therein) to clients, who wired funds

directly to LTD’s account in San Antonio. 

On its own, albeit pursuant to the criteria established by

Inver Group and only from banks that had been approved by Mr.

Zollino, INC purchased certificates of deposit or term deposits

in either the client’s name (for amounts greater than $98,000) or

in LTD’s name (for amounts less than $98,000, in increments of

$10,000). INC purchased the certificates of deposit and term

deposits on behalf of LTD and LTD’s clients with great frequency
- 82 -

over the continuous period of time in issue. INC’s authority to

purchase certificates of deposit and term deposits was not

"limited only to unusual cases", and its authority was not

"separately secured" by INC from LTD "with respect to each

transaction effected." The exercise of INC’s authority was not

merely occasional or infrequent. Accordingly, we conclude that

INC exercised its authority to negotiate and to conclude

contracts with the regularity and continuity required by section

1.864-7(d)(i)(ii), Income Tax Regs. Consequently, we hold that

INC is a dependent agent who had "the authority to negotiate and

conclude contracts" in the name of the foreign corporation LTD

and "regularly" exercised such authority within the meaning of

section 1.864-7(d)(1)(i), Income Tax Regs.

As INC is a dependent agent which had "the authority to

negotiate and conclude contracts" in the name of LTD and

"regularly" exercised such authority over a continuous period of

time, INC’s office will not be disregarded in determining whether

LTD had an office or other fixed place of business within the

meaning of section 1.864-7(d), Income Tax Regs. Sec. 1.864-

7(d)(3)(i), Income Tax Regs. Accordingly, we conclude that INC’s

office is to be used in deciding whether LTD had "an office or

other fixed place of business in the United States" within the

meaning of section 1.864-7(d), Income Tax Regs. 

 As INC is a corporation, and respondent makes no argument

that its separate existence should be ignored, and as LTD had no
- 83 -

employees of its own in the San Antonio office, we do not apply

the factor of employee activity. Sec. 1.864-7(e), Income Tax

Regs.

Finally, section 1.864-7(f), Income Tax Regs., provides that

the fact that a foreign corporation is related in some manner to

another person who has an office or other fixed place of business

will not of itself mean that the related person’s office or other

fixed place of business is the foreign corporation’s office or

other fixed place of business unless the facts and circumstances

show that the foreign corporation is engaged in trade or business

in the United States through such office or fixed place of

business. Based on the record in the instant case, we conclude

that the facts and circumstances show that LTD was engaged in

trade or business in the United States through INC’s office in

San Antonio. As we have discussed, supra pp. 72-73, LTD's

involvement and activities in the San Antonio office were

extensive, continuous, and regular. Moreover, LTD has not shown

that it maintained any other office or fixed place of business. 

Accordingly, we conclude that the San Antonio office of INC is

the office or other fixed place of business of LTD for purposes

of section 1.864-7(f), Income Tax Regs. 

Pursuant to section 1.864-7(a)(2), Income Tax Regs., we have

given "due regard" to the facts and circumstances of the instant

case, "particularly to the nature of the taxpayer's trade or

business and the physical facilities actually required by the
- 84 -

taxpayer in the ordinary course of the conduct of his trade or

business." The nature of LTD’s trade or business is to provide

Mexican investors with access to non-Mexican financial markets. 

The physical facility actually required by LTD in the ordinary

course of the conduct of its trade or business is a place that

can receive investment instructions from clients, effect such

instructions, and maintain records of actions that have been

taken. LTD had no place that received clients’ investment

instructions, effected such instructions, and maintained records

of actions taken, other than the San Antonio office. In sum, we

conclude that LTD had "an office or other fixed place of business

in the United States" within the meaning of section 1.864-7(d),

Income Tax Regs. 

Consequently, we hold that LTD’s trading in stocks or

securities fails to qualify for exclusion pursuant to section

864(b)(2)(A)(i) for each of two reasons: (1) The trading in

stocks or securities was not carried out through an "independent"

agent, and (2) LTD had "an office or other fixed place of

business in the United States" through which such transactions

were effected. See sec. 864(b)(2)(C). Accordingly, such trading

activities are taken into account to determine whether LTD was

engaged in "trade or business within the United States" pursuant

to section 864(b). 

We turn next to the exclusion allowed to taxpayers trading

for their own account. Section 864(b)(2)(A)(ii) provides that
- 85 -

certain activities are to be excluded from the definition of

"trade or business within the United States," to wit:

Trading in stocks or securities for the taxpayer's own

account, whether by the taxpayer or his employees or

through a resident broker, commission agent, custodian,

or other agent, and whether or not any such employee or

agent has discretionary authority to make decisions in

effecting the transactions. * * * 

Trading in stocks or securities, equated in the regulations with

"the effecting of transactions in the United States in stocks or

securities," includes:

buying, selling (whether or not by entering into short

sales), or trading in stocks, securities, or contracts

or options to buy or sell stocks or securities, on

margin or otherwise, for the account and risk of the

taxpayer, and any other activity closely related

thereto (such as obtaining credit for the purpose of

effectuating such buying, selling, or trading). * * * 

[Sec. 1.864-2(c)(2)(i), Income Tax Regs.]

The exclusion for trading in stocks or securities for the

taxpayer's own account, however, does not apply to: (1) A dealer

in stock or securities, and (2) a corporation (other than one

described in the parenthetical clause of section

864(b)(2)(A)(ii)) whose principal business is trading in stocks

or securities for its own account and whose principal office is

in the United States. Sec. 864(b)(2)(A)(ii). A dealer in stocks

or securities is defined as "a merchant of stocks or securities,

with an established place of business, regularly engaged as a

merchant in purchasing stocks or securities and selling them to

customers with a view to the gains and profits that may be

derived therefrom." Sec. 1.864-2(c)(2)(iv)(a), Income Tax Regs. 
- 86 -

In the determination of whether a person is a dealer in stocks or

securities, "such person's transactions in stocks or securities

effected both in and outside the United States shall be taken

into account." Id. The term "securities" for purposes of

paragraph (c) of section 1.864-2, Income Tax Regs., means "any

note, bond, debenture, or other evidence of indebtedness, or any

evidence of an interest in or right to subscribe to or purchase

any of the foregoing." Sec. 1.864-2(c)(2)(i), Income Tax Regs. 

Although the general rule is that a dealer in stocks or

securities is ineligible for the exclusion of trading for the

taxpayer's own account, certain types of dealers are excepted

from that general rule by section 1.864-2(c)(2)(iv)(b), Income

Tax Regs., which provides that 

A foreign person who otherwise may be considered a

dealer in stocks or securities under (a) of this

subdivision shall not be considered a dealer in stocks

or securities for purposes of this subparagraph--

 * * * * * * *

(2) Solely because of transactions effected in the

United States in stocks or securities pursuant to his grant

of discretionary authority to make decisions in effecting

those transactions, if he can demonstrate to the

satisfaction of the Commissioner that the broker, commission

agent, custodian, or other agent through whom the

transactions were effected acted pursuant to his written

representation that the funds in respect of which such

discretion was granted were the funds of a customer who is

neither a dealer in stocks or securities, * * * or a foreign

corporation described in subdivision (iii)(b) of this

subparagraph. * * *

For purposes of the foregoing exception (for certain dealers), a

foreign person includes, inter alia, a nonresident alien
- 87 -

individual and a foreign corporation. Sec. 1.864-2(c)(2)(iv)(b),

Income Tax Regs. The exception applies, however, "only if the

foreign person at no time during the taxable year has an office

or other fixed place of business in the United States through

which, or by the direction of which, the transaction in stocks or

securities are effected." Id.

Section 864(b)(2)(A)(ii) describes the second type of

foreign person that is ineligible for the exclusion of trading

for one’s own account, to wit: 

A corporation (other than a corporation which is, or

but for section 542(c)(7), 542(c)(10), or 543(b)(1)(C),

would be, a personal holding company) the principal

business of which is trading in stocks or securities

for its own account, if its principal office is in the

United States.

Petitioners argue that certain of LTD’s trading activities

are eligible to be excluded pursuant to section 864(b)(2)(A)(ii)

from the determination of whether LTD is engaged in "trade or

business within the United States" pursuant to section 864(b). 

Specifically, petitioners argue that the transactions LTD

undertook in its own name qualify for exclusion pursuant to

section 864(b)(2)(A)(ii). Additionally, petitioners contend that

the transactions LTD undertook in its clients' names qualify for

exclusion pursuant to the exception for certain dealers in stocks

or securities provided in section 1.864-2(c)(2)(iv)(b)(2), Income

Tax Regs. Petitioners argue that the foreign corporation

exception to the exclusion does not apply in the instant case
- 88 -

16

See supra note 13.

because LTD's principal business was not trading in stocks or

securities for its own account and because LTD's principal office

was located outside the United States during each of such years. 

Respondent argues that the section 864(b)(2)(A)(ii)

exclusion of trading for the taxpayer's own account does not

apply to any of the transactions in LTD’s financial services

business. Additionally, respondent argues that the exception in

section 1.864-2(c)(2)(iv)(b)(2), Income Tax Regs., is unavailable

because LTD had an office or other fixed place of business in the

United States. 

We agree with respondent. In the instant case, LTD was

regularly engaged in purchasing certificates of deposit and term

deposits from U.S. and foreign banks as attorney in fact for its

clients and was regularly engaged in selling evidences of an

interest in such financial instruments with a view to making

profits from such transactions. The certificates of deposit and

term deposits purchased by LTD are "evidences of indebtedness"

and are therefore securities within the meaning of section 1.864-

2(c)(2)(i), Income Tax Regs.16 The interests in IFF and the nonU.S. certificates of deposit are "interests in evidences of

indebtedness" and are therefore securities within the meaning of
- 89 -

17

Id.

section 1.864-2(c)(2)(i), Income Tax Regs.17 Additionally, LTD

had a fixed place of business in the United States, viz, the San

Antonio office, through which such transactions were effected. 

See supra p. 81.

We conclude that none of the transactions in LTD's financial

services business qualify for the exclusion pursuant to section

864(b)(2)(A)(ii). The transactions that LTD undertook in its own

name were not of the type contemplated by the statute. LTD did

not purchase and sell securities for its own account for the

purpose of investment or speculation within the meaning of

section 1.864-2(c)(2)(iv)(a), Income Tax Regs. The transactions

in LTD’s own name were part of its regular, continuous, and

extensive business of purchasing certificates of deposit with its

clients’ funds, as attorney in fact for the clients, with a view

to making commissions or other profits from such transactions. 

The office in San Antonio was instrumental to the conduct of that

business. Based on the foregoing, we hold that LTD did not

effect the transactions in question for its own account within

the meaning of section 864(b)(2)(A)(ii). Insofar as LTD may have

purchased any of the certificates of deposit for its own account,

we conclude that LTD was "a dealer in stocks or securities"

within the meaning of section 1.864-2(c)(2)(iv), Income Tax
- 90 -

18

We hold in the instant case that the exception of certain

dealers contained in sec. 1.864-2(c)(2)(iv)(b)(2), Income Tax

Regs., does not apply because LTD had "an office or other fixed

place of business in the United States through which, or by the

direction of which, the transactions in stocks or securities are

effected" within the meaning of sec. 1.864-2(c)(2)(iv)(b), Income

Tax Regs. See supra pp. 79, 84. 

Regs.18 Consequently, we hold that LTD’s securities trading is

not excluded pursuant to section 864(b)(2)(a)(ii) from the

determination of whether LTD was engaged in "trade or business

within the United States" pursuant to section 864(b).

Petitioners also argue that all of the activities that LTD

performed are excluded by case law from the consideration of

whether LTD was engaged in "trade or business within the United

States" within the meaning of section 864(b). Petitioners argue

that, "as a matter of law, the fact that INC was or was not a

dependent agent of LTD, or that its offices were or were not

LTD’s offices, is largely irrelevant." Petitioners contend that

"Whether or not INC was independent will not determine whether

LTD engaged in trade or business within the United States". 

Relying on Scottish Am. Inv. Co., Ltd. v. Commissioner, 12 T.C.

49 (1949), petitioners argue that the law concerns itself with

the "character and purpose" of the U.S. activities.

Respondent contends that, pursuant to the facts and

circumstances test of section 1.864-2(e), Income Tax Regs., LTD

was engaged in trade or business within the United States. 

Respondent contends that the test for determining if a taxpayer
- 91 -

is engaged in "trade or business within the United States" is

whether substantial profit-oriented activities regularly and

continuously occur in the United States whether carried on

directly by the taxpayer or through agents. 

Petitioners rely on a line of cases holding that the mere

maintenance of records and collection of rents, interest, or

dividends through managerial attention to securities does not

constitute trade or business. See, e.g., Higgins v.

Commissioner, 312 U.S. 212, 218 (1941); Continental Trading, Inc.

v. Commissioner, 265 F.2d 40 (9th Cir. 1959); DeKrause v.

Commissioner, T.C. Memo. 1974-291. The taxpayer in each of those

cases managed only personal investments and/or personal

investment income. Because those cases did not address taxpayers

who managed the investments of others, as did LTD, we conclude

that they are not dispositive of the instant case. 

Petitioners also cite several cases which are

distinguishable on their facts, to wit: Piedras Negras

Broadcasting Co. v. Commissioner, 127 F.2d 260 (5th Cir. 1942),

affg. 43 B.T.A. 297 (1941); Abegg v. Commissioner, 50 T.C. 145

(1968), affd. 429 F.2d 1209 (2d Cir. 1970), and Amalgamated

Dental Co. v. Commissioner, 6 T.C. 1009 (1946). In Piedras

Negras, the court held that none of the taxpayer’s income was

derived from sources within the United States. Piedras Negras

Broadcasting Co. v. Commissioner, supra at 261. In the instant

case, we conclude that the main situs of LTD’s income-producing
- 92 -

activities was the San Antonio office. Consequently, we conclude

that Piedras Negras does not support petitioners’ position in the

instant case. 

In Abegg, the taxpayer engaged in activities that were not

as substantial in both quantity and quality as LTD’s activities

in the instant case. In Abegg, the taxpayer engaged in

activities solely for its own benefit (viz, collecting dividends

and interest, managing existing investments, and investigating

new investments). Abegg v. Commissioner, supra at 153-154. In

contrast, in the instant case, LTD had clients to whom it

provided services and marketed investment products. 

Additionally, in Abegg, the taxpayer had operations in the United

States that we characterized as "planning activities", id. at

154, in contrast to LTD’s operations in the instant case, where

LTD’s U.S. operations dealt with third parties and therefore

consisted of more than mere "planning activities". Consequently,

we conclude that Abegg is not dispositive of the instant case. 

In Amalgamated Dental, the Court held that the taxpayer was

not "engaged in trade or business within the United States"

because the relationship between the parties was that of

vendor/vendee. Amalgamated Dental Co. v. Commissioner, supra at

1015-1016. We conclude that the facts in the instant case are

distinguishable from those in Amalgamated Dental. The

relationship between LTD and INC was not that of vendor/vendee. 

LTD delegated authority to INC, which, inter alia, purchased
- 93 -

certificates of deposit in LTD’s name. Accordingly, we conclude

that Amalgamated Dental is not dispositive of the instant case. 

Petitioners also rely heavily on Spermacet Whaling &

Shipping Co. S/A v. Commissioner, 30 T.C. 618 (1958). In

Spermacet, this Court addressed the issue of whether the taxpayer

was "engaged in trade or business within the United States"

within the meaning of section 231(b) of the 1939 Code, as

amended. The taxpayer entered into a contract to provide

management services for whaling boats. The Court held that the

"business in which * * * [the taxpayer] was engaged was that of

managing the [whaling] expedition" and that the taxpayer’s

"activities which produced the income in question took place

almost entirely on the high seas or in Norway." Id. at 633. 

Additionally, the Court held that the activities that the

taxpayer performed within the United States were "without

substance." Id. The Court stated: 

* * * [the actions in the United States of the

taxpayer’s forty percent shareholder] in receiving

monthly statements or correspondence involving * * *

[the taxpayer], or in paying a limited number of

obligations requiring payment in American dollars out

of a bank account * * * maintained by * * * [the

taxpayer], were ministerial and clerical in nature,

involving very little exercise of discretion or

business judgment necessary to the production of the

income in question. * * * [Id. at 633-634.]

Finally, "The holding of the directors’ meetings in New York City

solely for the personal convenience of the directors was of no

particular consequence." Id. at 634. Accordingly, the Court
- 94 -

stated that "we are convinced that * * * [the taxpayer] was not

engaged in any substantial, regular, or continuous ordinary

business activity in the United States." Id. at 634. 

We conclude that the facts in the instant case are

distinguishable from those in Spermacet. LTD's activities in the

United States, as conducted by LTD directly and through INC,

exceeded the mere receipt of LTD’s own monthly statements or

correspondence and limited payments of bills from a bank account. 

LTD received clients’ funds and placed such funds with third

parties. Additionally, LTD’s activities in the United States

were more extensive than the taxpayer’s "ministerial and

clerical" activities in Spermacet. LTD traded in stocks or

securities in the United States. A substantial part of the

activities that produced LTD’s income took place in San Antonio. 

In sum, we conclude that Spermacet Whaling & Shipping Co. S/A v.

Commissioner, supra, is not dispositive of the instant case. 

We also conclude that petitioner’s reliance on Scottish Am.

Inv. Co., Ltd. v. Commissioner, 12 T.C. 49 (1949), is without

merit. In Scottish American, this Court addressed the issue of

whether a group of Scottish trusts, by virtue of the activities

of an office in the United States, were "engaged in trade or

business within the United States" within the meaning of section

231(b) of the 1939 Code, as amended. The Court found the

following facts:
- 95 -

All judgments as to investments, the purchase and

sale of securities, and substantially all other major

policy decisions were made by officers in the home

office of the trusts situated outside of the United

States; orders for purchase and sale of securities were

executed by * * * [the trusts] directly through

resident banks in the United States; * * * the American

office’s activities were * * * confined to routine and

clerical functions performed by the banks prior to

1936. * * * [Id. at 55-56; fn. ref. omitted.]

The trusts' office, located in Jersey City, New Jersey,

performed the following activities: Collected, verified,

deposited, and remitted to the trusts dividend and interest

payments; exercised voting rights; maintained records for the

trusts; obtained and forwarded investment information to the

trusts; prepared tax returns; leased an office; and paid

expenses. Id. at 56-57. 

The Court held that the Scottish trusts were not "engaged in

trade or business within the United States" within the meaning of

former section 231(b), as amended. The Court reasoned that 

the real business of * * * [the trusts], the doing of

what they were principally organized to do in order to

realize profit, was the cooperative management in

Scotland of British capital, a large part of which was

invested by them in American securities through

transactions effected through resident brokers. To

this business of * * * [the trusts], the business

activities of the American office were merely helpfully

adjunct. No consequential transactions were effected

through or by the direction of the Jersey City office. 

It functioned primarily as a clerical department

performing a number of useful routine and incidental

services for * * * [the trusts]. But it can not be

said here that the local office, even though we look at

its activities as a whole, was doing what was

principally required to be done by * * * [the trusts]
- 96 -

in order to realize profit, or that its activities

constituted a business which * * * [the trusts] carried

on within the United States. * * * [Id. at 59; fn.

ref. omitted.]

 

The Court observed that, with respect to cases involving a

determination of whether or not a taxpayer is "engaged in trade

or business within the United States", "it is a matter of degree,

based upon both a quantitative and a qualitative analysis of the

services performed, as to where the line of demarcation should be

drawn." Id. The Court concluded that "It is not so much the

volume of the activities of the Jersey City office, although

volume of activities may, in some cases, be a factor, but rather

their character and the purpose for which the office is

established that we believe are determinative." Id. The Court

stated: 

We are not convinced that the services of this local

office, quantitatively extensive and useful as they may

have been, approached that quality which is necessary

in order that * * * [the trusts] can be characterized

as having engaged in business in the United States

during the years involved within the meaning of section

231(b). * * * [Id.]

The facts in the instant case are distinguishable from those

in Scottish American. In Scottish American, the trusts’ office

in the United States did not effect the trusts’ trading; the

trusts’ orders for purchases and sales of securities "were sent

directly from Scotland to resident brokers in the United States." 

Id. at 56. The trusts’ resident brokers were also their resident

banks, J.P. Morgan & Co. and the National City Bank of New York. 
- 97 -

Id. at 51. The trusts’ office in the United States was advised

of the purchases and sales executed by the resident brokers "so

that it would make the proper entries on its books." Id. at 56.

Unlike the trusts in Scottish American, LTD did not use

independent resident brokers to effect transactions in securities

for its own account during the years in issue. Rather, LTD’s

business consisted primarily of trading for its clients’ accounts

through transactions effected by its wholly owned subsidiary INC

at the latter’s office in the United States. In sum, we conclude

that Scottish American is not dispositive of the instant case. 

Consequently, we conclude that case law does not allow LTD to

exclude any of its trading activities from the consideration of

whether it was engaged in "trade or business within the United

States" pursuant to section 864(b). 

One final inquiry into the issue of whether LTD was engaged

in "trade or business within the United States" remains. 

Although LTD’s trading activities are not eligible for exclusion

from "the performance of personal services" for purposes of

section 864(b), LTD is not automatically deemed to be engaged in

"trade or business within the United States." Sec. 1.864-2(e),

Income Tax Regs. The fact that a party "is not determined by

reason of this section to be not engaged in trade or business

within the United States is not to be considered a determination

that such person is engaged in trade or business within the

United States." Id. Whether such a person is engaged in trade
- 98 -

or business within the United States "shall be determined on the

basis of the facts and circumstances in each case." Id. 

Accordingly, pursuant to section 1.864-2(e), Income Tax

Regs., we apply the relevant case law, which provides tests

regarding the amount of activity that is required for a

conclusion that a taxpayer is engaged in "trade or business

within the United States" pursuant to section 864(b). Finding no

cases addressing the term "trade or business within the United

States" as used in section 864(b), we turn to the cases

interpreting the statutory precursors of section 864 and section

882(a).

In European Naval Stores Co., S.A. v. Commissioner, 11 T.C.

127 (1948), the Court addressed whether the taxpayer, a foreign

corporation, was “engaged in trade or business within the United

States” within the meaning of section 231(b) of the 1939 Code, as

amended. In interpreting former section 231(b), the Court held

that the "question as to what activities of a taxpayer constitute

the carrying on of a business is one of fact." Id. at 132

(citing Higgins v. Commissioner, 312 U.S. 212 (1941), which

interpreted the phrase "carrying on any trade or business" within

the meaning of section 23(a) of the Revenue Act of 1932 (a

precursor of section 162(a))). The Court in European Naval

Stores indicated that the phrase "engaged in trade or business

within the United States" refers to profit-seeking activities

that are sufficiently regular, continuous, and extensive to
- 99 -

constitute "carrying on a trade or business" within the meaning

of section 162. The Court added:

The meaning of the phrases "engaged in business,"

"carrying on business," and "doing business" were

defined by the Circuit Court of Appeals for the Third

Circuit in Lewellyn v. Pittsburgh, B. & L.E.R. Co., 222

Fed. 177. It was stated therein that, "The three

expressions, either separately, or connectedly, convey

the idea of progression, continuity, or sustained

activity. 'Engaged in business' means occupied in

business; employed in business. 'Carrying on business'

does not mean the performance of a single disconnected

business act. It means conducting, prosecuting, and

continuing business by performing progressively all the

acts normally incident thereto, and likewise the

expression 'doing business', when employed as

descriptive of an occupation, conveys the idea of

business being done, not from time to time, but all the

time. * * *". [Id. at 133.]

 

In Scottish Am. Inv. Co., Ltd. v. Commissioner, 12 T.C. 49

(1949), the Court addressed whether the taxpayers, foreign

investment trusts, were, by virtue of maintaining a U.S. office,

"engaged in trade or business within the United States" within

the meaning of section 231(b) of the 1939 Code, as amended. The

Court examined "the real business of * * * [the taxpayers], the

doing of what they were principally organized to do in order to

realize profit". Id. at 59 and n.14 (citing Edwards v. Chile

Copper Co., 270 U.S. 452, 455 (1926)). In Scottish American, the

Court decided that the taxpayers’ real business was "the

cooperative management in Scotland of British capital" and that

"the business activities of the American office were merely

helpfully adjunct." Id. at 59. Additionally, the Court stated
- 100 -

that, "In cases such as these * * * [regarding whether the

taxpayer is engaged in trade or business within the United

States], it is a matter of degree, based upon both a quantitative

and a qualitative analysis of the services performed, as to where

the line of demarcation should be drawn." Id. In Scottish

American, the Court decided that the factors to be examined were

the "character" of the activities performed in the U.S. office,

"the purpose for which the office * * * [was] established", and,

to a lesser extent, "the volume of the activities". Id. 

In Spermacet Whaling & Shipping Co. S/A v. Commissioner, 30

T.C. 618 (1958), the Court addressed whether the taxpayer, a

foreign corporation, was "engaged in trade or business within the

United States" within the meaning of section 231(b) of the 1939

Code, as amended. In interpreting former section 231(b), the

Court stated:

We have consistently held that before a taxpayer

can be found to be "engaged in trade or business within

the United States" it must, during some substantial

portion of the taxable year have been regularly and

continuously transacting a substantial portion of its

ordinary business in this country. * * * [Id. at 634

and n.10 (citing, inter alia, European Naval Stores

Co., S.A. v. Commissioner, supra, and Scottish American

Investment Co. v. Commissioner, supra).]

After summarizing the test pursuant to former section 231(b), the

Court concluded that the taxpayer was not "engaged in any

substantial, regular, or continuous ordinary business activity in

the United States." Id. at 634. 
- 101 -

Petitioners contend that LTD’s "real business" was "to

render investment advice to clients in Mexico." Accordingly,

petitioners argue that all of the activities relating to LTD’s

business occurred in Mexico: LTD’s clients were solicited and

advised by Mexican-based promoters in Mexico, their accounts were

opened and approved in Mexico, clients changed their investment

portfolios in consultation with their Mexican promoter, and the

spread (where applicable) was negotiated in Mexico. Petitioners

contend that INC performed merely ministerial activities in the

United States and did not render any investment advice to clients

in Mexico. On those premises, petitioners conclude that LTD’s

"real business"--even if INC’s activities were imputed to LTD--

did not occur in the United States. 

We disagree. Contrary to petitioners’ argument, we believe

that the term "performance of personal services within the United

States" for purposes of section 864(b) does not require that LTD

itself perform such "personal services" in order to be engaged in

"trade or business within the United States." 

We first look to the "real business" of the taxpayers, the

"doing of what * * * [the taxpayers] were principally organized

to do in order to profit". Scottish Am. Inv. Co., v.

Commissioner, supra at 59. LTD is a corporation organized

pursuant to the laws of the Cayman Islands. Based on the record,

we believe that the "real business" of LTD, the doing of what LTD
- 102 -

was "principally organized to do in order to realize profit", was

to enable Mexican nationals to invest their capital in nonMexican financial markets. LTD’s "real business" was not merely

to render investment advice to clients in Mexico, as petitioners

contend. During each of the years in issue, LTD’s income

consisted of four major categories: Management fees, interest

income, currency transactions fees, and other fees and

commissions. LTD’s income, therefore, was derived from

effecting, primarily in the United States, transactions in

financial markets. Accordingly, we conclude that LTD’s "real

business" was providing Mexican nationals with access to nonMexican financial markets and that such business was conducted

primarily in the United States. 

In Scottish Am. Inv. Co. v. Commissioner, supra at 59, the

Court made "a quantitative and a qualitative analysis of the

services performed". Quantitatively, LTD performed a substantial

number of services in the United States. LTD maintained a client

clearing account at Frost Bank in San Antonio in which it

collected deposits from clients. During the years in issue, LTD

had approximately the following number of client accounts: 257

during 1985, 434 during 1986, 557 during 1987, 870 during 1988,

and 1,131 during 1989. Not all client accounts were actively

traded. Nonetheless, we conclude that the number of LTD’s client

accounts, and, as a corollary, the number of services performed
- 103 -

in the United States for such accounts, during each of the years

in issue, can be characterized as quantitatively substantial. 

Qualitatively, LTD performed substantial services in the

United States. Directly and through its agent INC, LTD provided

investment management services and marketed investment products. 

The purpose for which LTD was established was to provide access

to non-Mexican financial markets, and LTD conducted such business

primarily in the United States. We therefore conclude that LTD’s

activities in the United States during each of the years in issue

can be characterized as qualitatively substantial. 

In sum, we conclude that LTD "engaged in * * * substantial,

regular, or continuous ordinary business activity in the United

States." Spermacet Whaling & Shipping Co. S/A v. Commissioner,

supra at 634. We find that LTD’s activities in the United

States, conducted directly or through agents, included: 

Receiving client funds, monitoring interest rates, effecting

trades, collecting and disbursing dividends and interest,

maintaining customer account information, and valuing portfolios. 

Accordingly, we conclude that, during the years in issue, LTD was

"engaged in business in the United States" within the meaning of

section 1.864-4(c)(5)(i), Income Tax Regs. Consequently, we hold

that LTD was "engaged in the active conduct of a banking,

financing, or similar business in the United States" pursuant to

section 1.864-4(c)(5)(i), Income Tax Regs. A fortiori, we hold

that LTD was engaged in "trade or business within the United
- 104 -

States" pursuant to section 864(b) for its taxable years June 30,

1985 through 1989.

B. Whether Each Item of LTD's Income 

Was Effectively Connected 

1. Character and Source Rules

Before deciding whether an item of income is "effectively

connected with the conduct of trade or business within the United

States" pursuant to section 882(a)(1), we must first decide the

character and source of each item of income. Items of income

include, inter alia, personal services income and interest

income. Secs. 861(a) and 862(a). An item may be classified as

income from sources within the United States pursuant to section

861, as income from sources without the United States pursuant to

section 862, or as income partly from within and partly from

without the United States pursuant to section 863(b). 

Generally, income from the performance of personal services

has its source where the services are performed. Absent an

exception not applicable in the instant case, compensation for

labor or personal services performed in the United States is

treated as income from sources within the United States. Sec.

861(a)(3). Compensation for labor or personal services performed

without the United States is treated as income from sources

without the United States. Sec. 862(a)(3). 

For LTD's taxable years ended June 30, 1985 and 1986,

generally, the source of interest depends on the residence of the
- 105 -

obligor. Interest on bonds, notes, or other interest-bearing

obligations of U.S. residents, corporate or otherwise, is

generally treated as income from sources within the United

States. Sec. 861(a)(1). The term "resident of the United

States", used in section 1.861-2(a)(1), Income Tax Regs.

(promulgated pursuant to section 861(a)(1)), includes, inter

alia, "a foreign corporation or a foreign partnership, which at

any time during its taxable year is engaged in trade or business

in the United States." Sec. 1.861-2(a)(2)(iv), Income Tax Regs. 

Interest that is not treated as income from sources within

the United States pursuant to section 861(a)(1) is treated as

income from sources without the United States. Sec. 862(a)(1). 

Additionally, notwithstanding section 861(a)(1) and the

regulations thereunder, certain interest is treated as income

from sources without the United States. Sec. 1.861-2(b), Income

Tax Regs. 

For LTD's taxable years ended June 30, 1987 through 1989,

generally, the source of interest depends on the residence of the

obligor. Absent exceptions not applicable in the instant case,

interest on bonds, notes, or other interest-bearing obligations

of noncorporate residents or domestic corporations is treated as

income from sources within the United States. Sec. 861(a)(1). 

Interest that is not treated as income from sources within the

United States pursuant to section 861(a)(1) is treated as income

from sources without the United States. Sec. 862(a)(1). 
- 106 -

Generally, interest from foreign corporations is not treated as

income from sources within the United States pursuant to section

861(a)(1) and is therefore treated as income from sources without

the United States. Sec. 862(a)(1).

2. Application of the Character and Source Rules

a. Management Fees

Petitioners contend that the management fees received by LTD

are personal services income because such fees are compensation

for investment services. Petitioners argue that such services

included investment advice and related financial services that

LTD performed in managing the clients’ portfolios in Mexico. 

Petitioners argue that the persons performing the services were

the promoters and advisers working in district offices in Mexico. 

Petitioners contend that the management fees should be treated as

income from sources without the United States because the

services relating to the fees were provided in Mexico. 

Respondent concedes that the management fees are personal

services income because the fees are compensation for investment

services. Respondent, however, contends that the management fees

should be treated as income from sources within the United States

because the services relating to the management fees were

provided in San Antonio. 

In deciding whether the management fee income is from

sources within or from sources without the United States, we must

analyze the relationship LTD had with its clients. The primary
- 107 -

document interpreting that relationship is the discretionary

authorization, which states that the client is to pay LTD "as

full compensation for the services performed hereunder an annual

fee". The phrase "services performed hereunder" refers to the

four activities that the clients, by signing the discretionary

authorization, authorize LTD to perform. Those activities

include instructing banks on the disposition of client assets,

working with brokers on the disposition of client assets,

applying client deposits with LTD to client investments, and

paying bills for a client. In sum, the services listed in the

discretionary authorization do not include promoters’ services in

Mexico, as petitioners argue. The four activities for which the

management fee was paid all appear to be services that were

performed in San Antonio. Accordingly, we hold that the

management fee is characterized as compensation for personal

services performed in the United States and is treated as income

from sources within the United States. Sec. 861(a)(3).

b. Service Fees

(1) U.S. Certificates of Deposit

and Bank Deposits 

We must decide two issues: (1) The proper amount of income

in issue and (2) the proper characterization of such income. As

to the proper amount of income in issue, the parties stipulated

to the "Gross Receipts" and the "Direct Costs" relating to LTD’s 

"Interest Income". The "Gross Receipts" included all interest
- 108 -

19

Although the parties did not differentiate among the four

types of interest income from U.S. certificates of deposit, we

observe that there are four types of income earned by LTD from

U.S. certificates of deposit and bank deposits: the byte, the

basis income, the IFF spread, and the MMA spread. The byte, the

basis income, and the IFF spread are income derived from LTD’s

certificates of deposit operation. U.S. banks paid interest on

LTD’s certificates of deposit directly to LTD, which held such

instruments in its own name. The byte, the basis income, and the

IFF spread constitute portions of such interest from U.S.

certificates of deposit. The MMA spread, however, is income

derived from LTD’s bank accounts. The U.S. banks paid interest

on LTD’s bank account directly to LTD, which held the account in

its own name. The MMA spread constituted a portion of such

interest from U.S. banks.

paid to LTD,19 including the interest that LTD ultimately paid

out to its clients. The "Direct Costs" included, primarily, the

interest that LTD paid out to its clients. 

Petitioners contest the inclusion of the interest that LTD

paid out to its clients in LTD’s "Gross Receipts" and "Direct

Costs". Petitioners note that respondent imposes no tax on the

interest earned by LTD’s clients on certificates of deposit

purchased in their own name. Additionally, as to respondent’s

attempt to tax the interest earned on certificates of deposit

purchased in LTD’s name with the pooled funds of clients,

petitioners contend that the distinction in the name of the

instrument holder "does not justify the different tax treatment."

Petitioners, relying on Estate of Smith v. Commissioner, 313

F.2d 724 (8th Cir. 1963), affg. in part and revg. in part 33 T.C.

465 (1959), argue that the interest paid by LTD to its clients

should not be treated as gross income to LTD. Petitioners note
- 109 -

that "only the client’s principal had been invested." 

Petitioners argue that the mere act of pooling "did not alter the

essential relation among LTD, its clients and the clients’

funds." Finally, petitioners argue that "LTD did not become an

owner, with the client, in the * * * [certificate of deposit]

purchased." In sum, petitioners argue that all interest payments

are bifurcated: the portion retained by LTD was compensation for

services, and the portion received by LTD’s clients was interest

income to the clients themselves and not to LTD. 

As to the characterization of the "Interest Income",

petitioners contend that the income is personal services income. 

Petitioners note that the income represents the portion of the

interest earned on pooled investment funds that was retained by

LTD pursuant to the discretionary authorization. Accordingly,

petitioners, relying on Estate of Smith, argue that the character

of such income is compensation for services and not a portion of

the investment income of the pooled funds. Petitioners contend

that the investment management services that produced such income

were performed in Mexico, and therefore such income should be

treated as income from sources without the United States. 

Respondent’s primary argument is that the character of the

income is interest income from U.S. certificates of deposit and

bank deposits. Because such interest derived from a U.S.

obligor, respondent contends that, pursuant to the interest

source rules, the interest is treated as income from sources
- 110 -

within the United States. Alternatively, respondent argues that

the character of the income is personal services income

attributable to management activities performed in the United

States and therefore constitutes personal services income from

sources within the United States. 

 In Estate of Smith v. Commissioner, 33 T.C. 465 (1959),

Longstreet-Abbott & Co. (LACO), a commodities trading advisor

that was a partnership, offered its clients two investment

opportunities. The first type of investment was an "Individual

Trading Account" for which LACO purchased and sold, with capital

furnished by the client, commodity futures and spot commodities

in the name of the client. The second type of investment was a

common "fund" out of which LACO purchased and sold, with capital

furnished by several clients and pooled by LACO, commodity

futures and spot commodities in the name of the "fund". As its

compensation, LACO received a portion of the trading profit.

LACO "actively solicited individuals to participate in the

Funds" that it managed. Id. at 485. LACO’s "only expectation of

income was from the successful management of other individuals’

moneys." Id. LACO invested "no money of its own." Id. LACO

"only had authority to manage the Funds and to withdraw a certain

share of the profits" and was not permitted to withdraw any

portion of an investor’s cash contribution. Id. Finally, LACO

"had no economic interest in the commodity futures or spot

commodities as such, but only an interest in a share of the
- 111 -

profits which might be realized from the trading of the

commodities." Id. at 485-486. 

Based on those factors, we concluded: "It seems clear that

LACO was receiving a share of the profits in return for its

management services, and the gains it realized are ordinary

income both to LACO and to * * * [the taxpayers] composing LACO." 

Id. at 486. We then applied a similar analysis with regard to

the Individual Trading Accounts and sustained respondent’s

determination that LACO’s share of the profits was compensation

for services. Id. at 487. The Court of Appeals affirmed our

ruling on that issue "both with respect to the individual

investor accounts and the funds". 313 F.2d at 737. 

In the instant case, as to the proper amount of interest

income, we agree with petitioners that the interest earned by

LTD’s clients is not income to LTD. We conclude that LTD

functioned in a manner not unlike LACO in Estate of Smith, where

LACO, as the investment manager, was taxed only on its "share of

the profits", not on the entire gains derived from the trading. 

33 T.C. at 486. In the instant case, LTD purchased the

certificates of deposit or made bank deposits in its own name as

attorney in fact for its clients. LTD invested little, if any,

money of its own. LTD had no economic interest in the

certificates of deposit or bank deposits and only had an interest

in the spread between the rates earned from the investments and

the rates paid by LTD to its clients. Upon collecting the
- 112 -

interest from either certificates of deposit or bank deposits on

behalf of its clients, LTD paid to its clients their respective

portions of the interest and retained only LTD’s spread. 

Accordingly, we conclude that LTD should include in its income

only the amounts that it retained as interest spreads from

certificates of deposit and bank deposits.

As to the character of the income, we agree with petitioners

that LTD’s portion of the interest income is compensation for

services. We conclude that LTD functioned in a manner not unlike

LACO in Estate of Smith. LTD placed clients’ funds in

certificates of deposit and bank deposits in the client’s own

name and in LTD’s name. LTD’s only expectation of income was

from the management of its clients’ moneys, for which it received

a management fee, as discussed supra pp. 100-101. The rate

spreads that LTD retained also derived from placing its clients’

funds in certificates of deposit and bank deposits. Accordingly,

we conclude that such income was compensation for services. 

Based on the record, we believe that the activities from

which LTD earned its interest spreads were services that were

performed in San Antonio. Petitioners argue that the investment

management services performed in Mexico (i.e., the counseling of

clients) produced the income in issue. We disagree. As we view

the evidence in the instant case, we conclude that the most

important activity in producing the interest spread income was

the actual placing of funds in the certificates of deposit or the
- 113 -

bank deposits. LTD’s client clearing account, from which LTD

placed clients’ funds in certificates of deposit or bank

deposits, was located in Frost Bank in San Antonio. Accordingly,

we hold that the income from U.S. certificates of deposit and

bank deposits is characterized as compensation for personal

services performed in the United States and is treated as income

from sources within the United States. Sec. 861(a)(3).

(2) Non-U.S. Certificates of Deposit 

and Term Deposits 

As with LTD’s U.S. investment program, we must decide two

issues regarding LTD’s non-U.S. investment program: (1) The

proper amount of income in issue and (2) the proper

characterization of such income. As to the proper amount of

income in issue, based on our analysis regarding LTD’s U.S.

investment program, we similarly conclude that LTD should include

in its income only the amounts that it retained as interest

spreads from the non-U.S. certificates of deposit and term

deposits. 

As to the character of the income, petitioners contend that

the character of the income earned by LTD from non-U.S.

certificates of deposit and term deposits is interest income

which should be treated as income from sources without the United

States. Respondent, however, does not specifically address

either the character or the source of the income earned from nonU.S. certificates of deposit or term deposits. Respondent merely
- 114 -

argues that petitioners have failed to prove that the interest

income is foreign source income. 

We conclude that LTD’s portion of the interest income is

compensation for services. The non-U.S. investment program

consisted of purchases of certificates of deposit and term

deposits in banks outside the United States. LTD operated the

non-U.S. investment program in a manner similar to its U.S.

investment program. Accordingly, we apply our analysis of the

U.S. program, supra pp. 101-107, to the non-U.S. program and

conclude that the spread income was compensation for services. 

We believe that the activities from which LTD earned its

interest spreads were services that were performed in San

Antonio. We conclude that the most important activity in

producing the interest spread income was the actual placing of

funds in the certificates of deposit or the term deposits. LTD’s

client clearing account, from which LTD placed clients’ funds in

certificates of deposit or term deposits, was located in Frost

Bank in San Antonio. Accordingly, we hold that the income from

non-U.S. certificates of deposit and term deposits is

characterized as compensation for personal services performed in

the United States and is treated as income from sources within

the United States. Sec. 861(a)(3). 

(3) Pace Investments

Petitioners contend that the Pace investments were purchases
- 115 -

of certificates of deposit issued by foreign branches of Mexican

banks and that the character of the Pace investments income is

therefore interest income. Petitioners contend that the Pace

investments income is from sources without the United States

because the obligors were foreign. 

Respondent does not specifically address either the

character or the source of the Pace investments income. 

Respondent merely argues that petitioners have failed to prove

that the income is from a foreign source. 

Petitioners' contention that the Pace investments were

merely purchases of certificates of deposit issued by foreign

branches of Mexican banks is unsupported by the record. We

believe that the Pace investments constituted a specialized

mechanism for clients to draw upon their unused lines of credit. 

The income that LTD earned from its Pace investments was the

excess of (1) the sum of the interest earned from the Mexican

banks and the fees earned from the clients, over (2) the interest

paid to the clients as their stated rate of return. We conclude

that such income represented compensation for services rendered

in San Antonio in arranging the Pace investments. Accordingly,

we hold that the Pace investments income is characterized as

compensation for personal services performed in the United States

and is treated as income from sources within the United States. 

Sec. 861(a)(3).
- 116 -

c. Interest Income

(1) Loans

Petitioners do not address either the character or the

source of the income earned by LTD on its loans to clients and

Mexican corporations. 

Respondent contends that the character of the income from

LTD's loans is interest income. Respondent argues that the

income is attributable to interest on loans made to LTD's clients

and Mexican corporations. Because the debtors resided without

the United States, respondent contends that the interest is

treated as income from sources without the United States. 

We believe that LTD’s interest from loans was all paid by

Mexican individuals and corporations. Accordingly, we hold that

the interest is characterized as interest from non-U.S. obligors

and is treated as income from sources without the United States. 

Sec. 862(a)(1).

(2) MMA II

Petitioners contend that LTD’s MMA II income was interest

earned on client funds placed in non-U.S. bank deposits, thus

constituting income from sources without the United States.

Respondent agrees that the MMA II income was interest. 

Respondent, however, argues that petitioners have failed to prove

that the interest came from a foreign source. 

We find that, in the MMA II program, clients placed funds

with LTD and earned interest on such funds. Mexican corporations
- 117 -

borrowed such funds from LTD, which charged them interest. LTD's

MMA II income derived from the difference between the interest

that was charged and the interest that was paid out. 

Accordingly, we hold that the MMA II income is characterized as

interest from non-U.S. obligors and is treated as income from

sources without the United States. Sec. 862(a)(1).

d. Currency Exchange Transactions

Income (Currency Swaps

and Currency Transactions) 

Without distinguishing between the two types of currency

transactions, see supra pp. 41-43, petitioners contend that the

income earned by LTD from those transactions was compensation for

personal services rendered entirely in Mexico. Respondent

contends that the income was from personal services, or in the

alternative, was gain from the sale of personal property, and in

either event had its source solely within the United States. 

We conclude that LTD's income from currency transactions was

compensation for the performance of personal services rather than

gain from the purchases and sales of personal property. LTD

functioned as an intermediary, working in San Antonio and in

Mexico to effect its clients’ currency transactions. As to the

currency swaps, LTD’s income derived from commissions from Bank

of America and United States Trust. As to the currency

transactions, LTD’s income derived from the fees it charged its

clients for effecting the transactions. Accordingly, we hold

that the currency exchange transactions income is characterized
- 118 -

as compensation for personal services performed both in the

United States and outside the United States and is treated as

income from sources partly within and partly without the United

States. Sec. 863(b).

Petitioners, however, did not provide an apportionment

scheme for the currency exchange transactions income. The

Deloitte workpapers disclose that two income items derived

directly from the Guadalajara office's currency operations. 

Accordingly, we hold that, pursuant to section 863(b), each of

the Guadalajara income items is treated as income from sources

without the United States, and the remaining currency exchange

transactions income is treated as income from sources within the

United States.

e. Sales Commissions and Fees

(1) Currency Fund, FEIM Fund,

and Matric Fund

Petitioners contend that the character of the commissions

from the funds is compensation for investment services. 

Petitioners contend that the commissions should be treated as

income from without the United States because sales of each such

fund took place in Mexico. 

Respondent contends that the commissions should be treated

as income from sources within the United States because the

investment services relating to each such fund were provided in

San Antonio. 
- 119 -

We conclude that LTD’s Currency Fund commission is

compensation for investment services. As stated in its

promotional material, LTD acted as "Manager" of the Currency

Fund. The services that LTD rendered in relation to the Currency

Fund included accepting clients' deposits, opening an account

with a foreign bank, and issuing clients periodic statements. 

All of such activities were performed through the office in San

Antonio. We disagree with petitioners' contention that only the

selling of the fund is to be examined in deciding the source of

the commission income. LTD provided many services beyond the

initial sale of the fund. We conclude that LTD’s commission was

compensation for providing those services, not for selling the

fund. In sum, LTD’s management of the Currency Fund entailed

performing personal services in San Antonio. Accordingly, we

hold that LTD's Currency Fund commission is characterized as

compensation for personal services performed in the United States

and is treated as income from sources within the United States. 

Sec. 861(a)(3).

We similarly conclude that LTD’s FEIM Fund commission is

compensation for investment services. The services that LTD

rendered in relation to the FEIM Fund included accepting clients'

deposits, transferring those deposits to Merrill Lynch, and

issuing periodic statements to clients. All of those activities

were performed through the office in San Antonio. We disagree

with petitioners’ contention that only the selling of the fund is
- 120 -

to be examined in deciding the source of the commission income. 

LTD provided many services beyond the initial sale of the fund. 

We conclude that LTD’s commission was compensation for providing

those services, not for selling the fund. In sum, LTD’s

management of the FEIM Fund entailed performing personal services

in San Antonio. Accordingly, we hold that LTD's FEIM Fund

commission is characterized as compensation for personal services

performed in the United States and is treated as income from

sources within the United States. Sec. 861(a)(3). 

We similarly conclude that LTD’s Matric Fund commission,

initiation fee, and consulting fee are compensation for

investment services. The services that LTD rendered in relation

to the Matric Fund included handling the paperwork and general

administration, and administering the interest payments to the

investors. Clients placed their commitments with LTD through the

San Antonio office. LTD handled all paperwork regarding the

Matric Fund accrual of interest in the San Antonio office. We

disagree with petitioners’ contention that only the selling of

the fund is to be examined in deciding the source of the

commission income. LTD provided many services beyond the initial

sale of the fund. We conclude that LTD’s commission was

compensation for providing such services, not for selling the

fund. In sum, LTD’s management of the Matric Fund entailed

performing personal services in San Antonio. Accordingly, we

hold that LTD's Matric Fund income is characterized as
- 121 -

compensation for personal services performed in the United States

and is treated as income from sources within the United States. 

Sec. 861(a)(3).

(2) Inversat Fund

Petitioners contend that the character of the Inversat Fund

commission is personal services income because such commission is

compensation for investment services. Petitioners contend that

the commission should be treated as income from sources without

the United States because the services relating to the Inversat

Fund commission were provided in Mexico. Petitioners do not

specify the services relating to the Inversat Fund that are

relevant for sourcing purposes.

Respondent contends that the commission should be treated as

income from sources within the United States. 

We conclude that LTD’s Inversat Fund commission was

compensation for investment services. The services that LTD

rendered in relation to the Inversat Fund included accepting

clients' deposits, transferring the funds from Inversat Fund to

Inversat REIT, and general investment management, all of which

were performed through the office in San Antonio. In sum, LTD’s

management of the Inversat Fund entailed performing personal

services in San Antonio. Accordingly, we hold that LTD's

Inversat Fund commission is characterized as compensation for

personal services performed in the United States and is treated

as income from sources within the United States. Sec. 861(a)(3). 
- 122 -

(3) TVA

Petitioners contend that the character of the TVA commission

is personal services income because such commission is

compensation for investment services. Petitioners contend that

the commission should be treated as income from without the

United States because the services relating to the TVA project

were provided in Mexico. Petitioners argue that the

services relating to the TVA project relevant for sourcing

purposes include only the underwriting activities. Petitioners

maintain that the TVA project's only connection to the United

States was that INC recorded money going in or out of a client

account. 

Respondent contends that the commission should be treated as

income from sources within the United States because the

investment services relating to the TVA project were provided in

San Antonio.

The TVA commission includes three types of income, and we

analyze each type individually. As to the first type of income,

we conclude that LTD’s 5-percent commission on the total funds

raised was compensation for personal services. The services that

LTD rendered in relation to the 5-percent commission included

formulating the prospectus and executing the marketing program to

solicit venture capital. We conclude that such services were

performed in Mexico. In sum, LTD’s activities relating to the 5-

percent commission consisted of performing personal services in
- 123 -

Mexico. Accordingly, we hold that LTD's 5-percent commission is

characterized as compensation for personal services performed

outside the United States and is treated as income from sources

without the United States. Sec. 862(a)(3). 

As to the second type of income, we conclude that LTD’s

monthly administration fee is compensation for personal services. 

The services that LTD rendered in relation to the fee included

administering the funds raised in the capital call. We conclude

that such services were performed in San Antonio. In sum, LTD’s

activities relating to the monthly administration fee consisted

of performing personal services in San Antonio. Accordingly, we

hold that LTD's monthly administration fee is characterized as

compensation for personal services performed in the United States

and is treated as income from sources within the United States. 

Sec. 861(a)(3). 

As to the third type of income, we conclude that LTD’s

percentage commission charged to certain clients purchasing units

in the trust is compensation for personal services. The services

that LTD rendered in relation to the percentage commission from

certain clients included formulating the prospectus and executing

the marketing program to solicit venture capital. We conclude

that such services were performed in Mexico. In sum, LTD’s

activities relating to the percentage commission consisted of

performing personal services in Mexico. Accordingly, we hold

that LTD's percentage commission is characterized as compensation
- 124 -

for personal services performed outside the United States and is

treated as income from sources without the United States. Sec.

862(a)(3). 

(4) Client Incorporation and Trust

Creation, Legal Advice

Income, and Letters of Credit 

Respondent contends that the character of the client

incorporation and trust creation fees, the legal advice income,

and the letters of credit fees are personal services income. 

Respondent contends that such income items should be treated as

income from sources within the United States because the

investment services relating to the income were provided in San

Antonio. 

Petitioners do not dispute respondent’s contentions. 

Consequently, we treat petitioners as having conceded that such

income is characterized as compensation for personal services

income performed in the United States and is treated as income

from sources within the United States. Sec. 861(a)(3). 

(5) Foreign Exchange Investments

We analyze LTD’s foreign exchange investments income in a

manner similar to that in the currency exchange transactions

section, supra pp. 110-112.

Petitioners, however, did not provide any basis for

apportionment of the foreign exchange investments income. 

Accordingly, we sustain respondent's determinations that such

income is characterized as compensation for personal services
- 125 -

performed in the United States and is treated entirely as income

from sources within the United States. Sec. 861(a)(3). 

(6) Treasury Bills, Wires and Checks,

Gold and Silver Futures, Project

Income, Income from Investments,

Other Commission Income, Other 

Commissions and Fees, 

and Other Income 

Petitioners do not specifically address either the character

or the source of such income items. Consequently, we treat

petitioners as having conceded such items. Accordingly, we

sustain respondent's determinations that the income in each such

category is characterized as compensation for personal services

income performed in the United States and is treated as income

from sources within the United States. Sec. 861(a)(3).

3. Effectively Connected Income Rules

a. Introduction to the Rules

A foreign corporation engaged in trade or business within

the United States is taxed on income which is "effectively

connected with the conduct of a trade or business within the

United States" (hereinafter effectively connected). Sec.

882(a)(1). For this purpose, income from sources within the

United States generally is segregated between two categories,

pursuant to section 864(c)(2) and (3). The income to which

section 864(c)(2) applies includes, inter alia, income described

in section 871(a)(1), section 871(h), section 881(a), or section
- 126 -

881(c). Compensation, interest (other than "portfolio"

interest), dividends, and other fixed or determinable annual or

periodical gains, profits, and income are income items described

in section 871(a)(1) and section 881(a) and are therefore subject

to the section 864(c)(2) rules. 

Section 864(c)(2) provides two general "factors" to consider

in determining whether income from sources within the United

States falling under its purview is effectively connected: (1)

Whether the income is derived from assets used in or held for use

in the conduct of the trade or business, sec. 864(c)(2)(A)

(asset-use test), and (2) whether the activities of the trade or

business were a material factor in the realization of the income,

sec. 864(c)(2)(B) (business-activities test). A special regime

applies pursuant to section 864(c)(2), however, in determining

whether the income of taxpayers "engaged in the active conduct of

a banking, financing, or similar business in the United States"

is effectively connected. Sec. 1.864-4(c)(5), Income Tax Regs. 

All income from sources within the United States other than

that covered by section 864(c)(2) or section 1.864-4(c)(5),

Income Tax Regs., falls into the residual category of section

864(c)(3) and is treated as effectively connected with any U.S.

trade or business conducted by the taxpayer (regardless of

whether an actual connection exists). 

Certain income from sources without the United States is

also deemed effectively connected if such income is attributable
- 127 -

to an office or other fixed place of business within the United

States. Sec. 864(c)(4)(B). Excepting foreign source income

deemed effectively connected pursuant to, inter alia, section

864(c)(4)(B), no foreign source income is treated as effectively

connected. Sec. 864(c)(4)(A).

b. Section 1.864-4(c)(5), Income

Tax Regs., Banking Activity Test

Once a taxpayer is determined to be engaged in the active

conduct of a banking business within the meaning of section

1.864-4(c)(5)(i), Income Tax Regs., set forth supra p. 64, then

the income of the taxpayer from sources within the United States

is placed in one of three categories, each of which provides an

effectively connected income test.

In the first category of income,

any dividends or interest from stocks or securities, or

any gain or loss from the sale or exchange of stocks or

securities which are capital assets, which is from

sources within the United States and derived by a

nonresident alien individual or a foreign corporation

in the active conduct during the taxable year of such

banking, financing, or similar business in the United

States shall be treated as effectively connected with

the conduct of that business * * * [Sec. 1.864-

4(c)(5)(ii), Income Tax Regs.]

only if two conditions are met: (1) "the stocks or securities

giving rise to such income, gain, or loss are attributable to the

U.S. office through which such business is carried on", and (2)

the stocks or securities either (a) were acquired in one of three

specified ways, or (b) consist of one of three specified types of

securities. Id. A security for purposes of section 1.864-
- 128 -

4(c)(5), Income Tax Regs., is defined as "any bill, note, bond,

debenture, or other evidence of indebtedness, or any evidence of

an interest in, or right to subscribe to or purchase, any of the

foregoing items." Sec. 1.864-4(c)(5)(v), Income Tax Regs. 

In the second category of income, any dividends or interest

from stocks or securities, or any gain or loss from the sale or

exchange of stocks or securities, which does not meet the

conditions described supra and therefore is not treated as

effectively connected with the taxpayer’s active conduct of a

banking, financing or similar business in the United States still

"may be effectively connected for the taxable year" with the

conduct of another business by the taxpayer in the United States

pursuant to either the asset-use test or the business-activities

test. Sec. 1.864-4(c)(5)(vi)(a), Income Tax Regs. In the last

category of income, any income, gain, or loss from sources within

the United States (other than dividends or interest from, or gain

or loss from the sale or exchange of, stocks or securities) is

determined to be effectively connected pursuant to either the

asset-use test or business-activities test. Sec. 1.864-

4(c)(5)(vi)(b), Income Tax Regs.

c. Section 864(c)(2)(A) Asset-use Test

The Code provides that one factor to consider in determining

whether income described in section 864(c)(2) is effectively
- 129 -

connected with a U.S. trade or business is whether "the income,

gain, or loss is derived from assets used in or held for use in

the conduct of such trade or business" (asset-use test). Sec.

864(c)(2)(A). Additionally, the Code provides that "due regard

shall be given to whether or not such asset or such income, gain,

or loss was accounted for through such trade or business." Sec.

864(c)(2). The regulations provide that the asset-use test

ordinarily applies "in making a determination with respect to

income, gain, or loss of a passive type where the trade or

business activities as such do not give rise directly to the

realization of the income, gain, or loss." Sec. 1.864-

4(c)(2)(i), Income Tax Regs. The regulations state that the test

is "of primary significance where, for example, interest or

dividend income is derived from sources within the United States

by a nonresident alien individual or foreign corporation that is

engaged in the business of manufacturing or selling goods in the

United States." Id.

d. Section 864(c)(2)(B)

Business-Activities Test

The Code provides that another factor to consider in

determining whether income is effectively connected to a U.S.

trade or business is whether "the activities of such trade or

business were a material factor in the realization of the income,

gain, or loss" (business-activities test). Sec. 864(c)(2)(B). 

Additionally, the Code provides that "due regard shall be given
- 130 -

20

The test articulated in sec. 1.864-4(c)(5)(i), Income Tax

Regs., regarding whether a foreign corporation is engaged in the

active conduct of "a banking, financing, or similar business in

the United States" is to be applied. Sec. 1.864-5(b)(2)(i),

Income Tax Regs. 

to whether or not such asset or such income, gain, or loss was

accounted for through such trade or business." Sec. 864(c)(2). 

The regulations provide that the business-activities test is of

primary significance in cases in which:

(a) dividends or interest are derived by a dealer in

stocks or securities, (b) gain or loss is derived from

the sale or exchange of capital assets in the active

conduct of a trade or business by an investment

company, (c) royalties are derived in the active

conduct of a business consisting of the licensing of

patents or similar intangible property, or (d) service

fees are derived in the active conduct of a servicing

business. * * * [Sec. 1.864-4(c)(3)(i), Income Tax

Regs.]

The regulations, however, add that 

In applying the business-activities test, activities

relating to the management of investment portfolios

shall not be treated as activities of the trade or

business conducted in the United States unless the

maintenance of the investments constitutes the

principal activity of that trade or business. * * *

[Id.]

 

e. Section 864(c)(4)(B) Rules for Income

From Sources Without the United States

Once a taxpayer is determined to be engaged in the active

conduct of a banking, financing, or similar business within the

meaning of section 1.864-5(b)(2)(i), Income Tax Regs.,20 then all

dividends and interest from sources without the United States are
- 131 -

placed in one of three categories, each of which provides an

effectively connected income test. In the first category of

income, any dividends or interest from stocks or securities, or

any gain or loss from the sale of exchange of stocks or

securities which are capital assets, which is from sources

without the United States and derived by a nonresident alien

individual or a foreign corporation in the active conduct during

the taxable year of a banking, financing, or similar business in

the United States, shall be treated as effectively connected

under the same principles of section 1.864-4(c)(5)(ii), Income

Tax Regs., that are applied to U.S. source dividends or interest

derived in the active conduct of a banking, financing, or similar

business in the United States. Sec. 1.864-6(b)(2)(ii)(b), Income

Tax Regs. Accordingly, such foreign source dividends, interest,

gain, or loss from stocks or securities are treated as

effectively connected income only if two conditions are met: (1)

"the stocks or securities giving rise to such income are * * *

attributable to the U.S. office through which such [banking,

financing, or similar] business is carried on", and (2) the

stocks or securities either (a) were acquired in one of three

ways, or (b) consist of one of three types of securities. Sec.

1.864-4(c)(5)(ii), Income Tax Regs.

In the second category of income, any dividends, interest,

gain, or loss from stocks or securities which does not meet the
- 132 -

conditions described supra and therefore is not treated as

effectively connected with the taxpayer’s active conduct of a

banking, financing or similar business in the United States,

still "may be effectively connected * * * [pursuant to section

1.864-6(b)(2)(ii)(a), Income Tax Regs.] for the taxable year * *

* with the conduct by such taxpayer of a trade or business in the

United States which consists of trading in stocks or securities

for the taxpayer’s own account." Sec. 1.864-6(b)(2)(ii)(d)(1),

Income Tax Regs. 

The last category of income consists of "dividends or

interest from sources without the United States * * * derived in

the active conduct of a banking, financing, or similar business

in the United States" other than dividends or interest from, or

gain or loss from the sale or exchange of, stocks or securities

described in the first category supra pp. 123-124. Sec. 1.864-

6(b)(2)(ii)(d)(2), Income Tax Regs. That category of dividends

and interest is subject to the same requirements as dividends and

interest of a taxpayer not engaged in the active conduct of a

banking, financing, or similar business. Id. Accordingly, the

dividends or interest is treated as effectively connected if the

taxpayer has "an office or other fixed place of business within

the United States to which such * * * [dividends or interest is]

attributable." Sec. 864(c)(4)(B); see sec. 1.864-6(b)(2)(ii)(a),

Income Tax Regs. 
- 133 -

For purposes of section 864(c)(4)(B), three rules apply in

determining whether the taxpayer has "an office or other fixed

place of business within the United States to which such income,

gain, or loss is attributable". Sec. 864(c)(5). 

The first rule is:

in determining whether a nonresident alien individual

or a foreign corporation has an office or other fixed

place of business, an office or other fixed place of

business of an agent shall be disregarded unless such

agent (i) has the authority to negotiate and conclude

contracts in the name of the nonresident alien

individual or foreign corporation and regularly

exercises that authority or has a stock or merchandise

from which he regularly fills orders on behalf of such

individual or foreign corporation, and (ii) is not a

general commission agent, broker, or other agent of

independent status acting in the ordinary course of his

business. * * * [Sec. 864(c)(5)(A).]

The regulations promulgated thereunder are set forth supra pp.

69-72. 

The second rule is:

income, gain, or loss shall not be considered as

attributable to an office or other fixed place of

business within the U.S. unless such office or fixed

place of business is a material factor in the

production of such income, gain or loss and such office

or fixed place of business regularly carries on

activities of the type from which such income, gain, or

loss is derived. * * * [Sec. 864(c)(5)(B)]

See also sec. 1.864-6(b)(1), Income Tax Regs. Additionally, the

income, gain, or loss must be "realized in the ordinary course of

the trade or business carried on through that office or other

fixed place of business." Sec. 1.864-6(b)(1), Income Tax Regs.

The regulations provide guidance in applying the material
- 134 -

factor test to specific classes of income. Sec. 1.864-6(b)(2),

Income Tax Regs. For dividends or interest, or gains or losses

from the sale or exchange of certain stocks or securities, an

office or other fixed place of business is considered a material

factor in the realization of such income, gain, or loss:

if the office or other fixed place of business either

actively participates in soliciting, negotiating, or

performing other activities required to arrange, the

issue, acquisition, sale, or exchange, of the asset

from which such income, gain, or loss is derived or

performs significant services incident to such issue,

acquisition, sale, or exchange. * * * [Sec. 1.864-

6(b)(2)(ii), Income Tax Regs.]

An office or other fixed place of business in the United States

is not considered to be a material factor in the realization of

income, gain, or loss: 

merely because the office or other fixed place of

business conducts one or more of the following

activities: (1) collects or accounts for the

dividends, interest, gains, or losses, (2) exercises

general supervision over the activities of the persons

directly responsible for carrying on the activities or

services described in the immediately preceding

sentence, (3) performs merely clerical functions

incident to the issue, acquisition, sale, or exchange,

or (4) exercises final approval over the execution of

the issue, acquisition, sale, or exchange. * * * [Sec.

1.864-6(b)(2)(ii)(a), Income Tax Regs.]

The third rule in pertinent part is that "the income, gain,

or loss which shall be attributable to an office or other fixed

place of business within the United States shall be the income,

gain, or loss properly allocable thereto." Sec. 864(c)(5)(C). 

The regulation thereunder provides no definition of the term
- 135 -

"properly allocable". Instead, the regulation provides the

general guideline that if an office or other fixed place of

business is "a material factor in the realization for that year

of an item of income, gain, or loss * * * such item of income,

gain, or loss shall be considered to be allocable in its entirety

to that office or other fixed place of business." Sec. 1.864-

6(c)(1), Income Tax Regs. 

Finally, any foreign source income initially deemed

effectively connected shall not be treated as effectively

connected if such income, assuming it were derived by the

taxpayer from sources within the United States for the taxable

year, "would not be treated under § 1.864-4 as effectively

connected for the taxable year with the conduct of a trade or

business in the United States." Sec. 1.864-5(a), Income Tax

Regs. In other words, foreign source income deemed effectively

connected pursuant to, inter alia, section 864(c)(4)(B) must also

meet the applicable effectively connected income tests of section

1.864-4, Income Tax Regs., i.e., the asset-use test, the

business-activities test, or the banking activity test, as if

such income were from sources within United States.

4. Application of the Effectively

Connected Income Rules 

We have held, supra p. 98, that LTD was "engaged in the

active conduct of a banking, financing, or similar business in

the United States" within the meaning of section 1.864-
- 136 -

4(c)(5)(i), Income Tax Regs. Because section 1.864-5(b)(2)(i),

Income Tax Regs., applies the test articulated in section 1.864-

4(c)(5)(i), Income Tax Regs, we also hold that LTD was "engaged

in the active conduct of a banking, financing, or similar

business in the United States” within the meaning of section

1.864-5(b)(2)(i), Income Tax Regs. Accordingly, we apply the

special effectively connected income rules for a foreign

corporation considered to be so engaged. 

a. Management Fees

Petitioners contend that the management fee is income from

sources without the United States. Petitioners contend that such

fee is not effectively connected income because it is not one of

the types of foreign source income that is deemed effectively

connected income pursuant to section 864(c)(4)(B) or (C). 

Respondent contends that the management fee is income from

sources within the United States. Respondent applies the

business-activities test only by implication and contends that

the fee is effectively connected income. 

We have held, supra p. 101, that the management fee is

characterized as compensation for personal services and is

treated as income from sources within the United States. 

Accordingly, as petitioners' effectively connected income

argument presumes foreign source income, we find that argument to

have no merit. Although respondent applies the business-
- 137 -

activities test only by implication, we are convinced that the

test is properly applied to the management fee. 

LTD’s management fee is any "income, gain, or loss from

sources within the United States" not already described in the

first two categories of U.S. source income and, therefore, falls

under the third category of U.S. source income of a foreign

corporation engaged in the active conduct of a banking,

financing, or similar business. Sec. 1.864-4(c)(5)(vi)(b),

Income Tax Regs. Accordingly, we analyze LTD’s management fee

pursuant to either the asset-use or business-activities test. 

Id.

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business". Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s management fee is a service

fee derived in the active conduct of a servicing business. 

Consequently, we apply the business-activities test to decide

whether such fee is effectively connected income. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We hold that such exception is

inapplicable because the maintenance of investments constitutes

the principal activity of LTD's trade or business within the
- 138 -

meaning of section 1.864-4(c)(3)(i), Income Tax Regs. Although

regulations do not define "principal activity" for the purposes

of section 1.864-4(c)(3)(i), Income Tax Regs., in interpreting

such words, we look to their "ordinary, everyday senses." 

Soliman v. Commissioner, 506 U.S. 168, 174 (1993), and the cases

cited therein. The term "principal" has been defined to mean

"most important, consequential, or influential." Id. at 174

(quoting Webster’s Third New International Dictionary 1802 (1971)

and defining "principal place of business" for purposes of the

home office deduction pursuant to section 280A(c)(1)).

In the instant case, the "maintenance" of investments, which

is equated in section 1.864-4(c)(3)(i), Income Tax Regs., to the

"management" of investments, constitutes the "most important,

consequential, or influential" activity of LTD's trade or

business as seen by both its total activities and total income. 

Accordingly, we conclude that the "maintenance" of investments

constitutes the principal activity of LTD's trade or business

within the meaning of section 1.864-4(c)(3)(i), Income Tax Regs. 

Consequently, we hold that LTD’s activities relating to the

management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test. 

In applying the business-activities test to decide whether

the management fee is effectively connected income, we must
- 139 -

consider whether "the activities of such trade or business were a

material factor in the realization of the income". Sec.

864(c)(2)(B). We have held, supra p. 98, that LTD was engaged in

"trade or business within the United States" pursuant to section

864(b) during its taxable years in issue. The activities of

LTD's trade or business relating to the management fee included

instructing banks on the disposition of client assets, working

with brokers on the disposition of client assets, applying client

deposits with LTD to client investments, and paying bills for

clients. We conclude that such activities of LTD’s trade or

business were "a material factor in the realization of the

income" within the meaning of section 864(c)(2)(B). We have

given due regard to the question of whether such income was

accounted for through such trade or business, and we find LTD's

management fee to have been accounted for through LTD's trade or

business. Sec. 864(c)(2). Consequently, we hold that LTD's

management fee is effectively connected income pursuant to

section 1.864-4(c)(5)(vi)(b), Income Tax Regs., and section

864(c)(2)(B). 

b. Service Fees

(1) U.S. Certificates of Deposit

and Bank Deposits 

Petitioners contend that the income from U.S. certificates

of deposit and bank deposits is personal services income from

sources without the United States. Petitioners contend that such
- 140 -

items are not effectively connected income because they do not

fall under one of the types of foreign source income which is

deemed effectively connected income pursuant to section

864(c)(4)(B) or (C). Alternatively, petitioners contend that

such items, if treated as income from sources within the United

States, cannot be effectively connected income because (1) they

fail the asset-use test as they were not derived by LTD from

assets used in the conduct of trade or business in the United

States, and (2) they fail the business-activities test as the

activities of any alleged U.S. trade or business of LTD were not

a material factor in the realization of the amounts of interest

income properly allocable to LTD. 

Respondent contends alternatively that the income from the

U.S. certificates of deposit and bank deposits is interest income

or personal services income from sources within the United

States. Respondent contends that such income items are

effectively connected because they pass the business-activities

test. Respondent argues that, as the activities of LTD's U.S.

business were a material factor in the realization of the

interest items, such items are effectively connected income. 

Additionally, respondent argues that, if the income from U.S.

certificates of deposit and bank deposits is determined not to be

effectively connected income, a tax of 30 percent is imposed

pursuant to section 881. 
- 141 -

We have held, supra pp. 106-107, that LTD's income from U.S.

certificates of deposit and bank deposits is characterized as

compensation for personal services and is treated as income from

sources within the United States. Accordingly, as petitioners'

first effectively connected income argument presumes foreign

source income, we find that argument to have no merit. 

Additionally, because we apply the business-activities test, we

need not address petitioners’ arguments regarding the asset-use

test.

LTD’s income from U.S. certificates of deposit and bank

deposits is any "income, gain, or loss from sources within the

United States" not already described in the first two categories

of U.S. source income and, therefore, falls under the third

category of U.S. source income of a foreign corporation engaged

in the active conduct of a banking, financing, or similar

business. Sec. 1.864-4(c)(5)(vi)(b), Income Tax Regs. 

Accordingly, we analyze LTD’s income from U.S. certificates of

deposit and bank deposits pursuant to either the asset-use or

business-activities test. Id. 

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business". Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s income from U.S. certificates

of deposit and bank deposits consists of service fees derived in
- 142 -

the active conduct of a servicing business. Consequently, we

apply the business-activities test to decide whether such income

is effectively connected income. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment portfolio management exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

LTD’s income from U.S. certificates of deposit and bank deposits

is effectively connected income, we must consider whether "the

activities of such trade or business were a material factor in

the realization of the income". Sec. 864(c)(2)(B). We have

held, supra p. 98, that LTD was engaged in "trade or business

within the United States" pursuant to section 864(b) during its

taxable years in issue. The activities of LTD's trade or

business relating to its income from U.S. certificates of deposit

and bank deposits included receiving clients’ funds, depositing

the funds in the client clearing account, either purchasing a

certificate of deposit from a U.S. bank or keeping the funds in
- 143 -

the client clearing account, and maintaining records of LTD’s and

its clients’ positions with respect to the investments or

deposits. We conclude that such activities of LTD’s trade or

business were "a material factor in the realization of the

income" within the meaning of section 864(c)(2)(B). We have

given due regard to the question of whether such income was

accounted for through such trade or business, and we find LTD’s

income from U.S. certificates of deposit and bank deposits to

have been accounted for through LTD’s trade or business. Sec.

864(c)(2). Consequently, we hold that LTD’s income from U.S.

certificates of deposit and bank deposits is effectively

connected income pursuant to section 1.864-4(c)(5)(vi)(b), Income

Tax Regs., and section 864(c)(2)(B).

(2) Non-U.S. Certificates of Deposit

and Term Deposits 

Petitioners contend that the income from non-U.S.

investments and term deposits is from sources without the United

States. Petitioners contend that such income is not effectively

connected income because LTD was not engaged in the active

conduct of a banking, financing, or similar business in the

United States, its principal business was not trading in stock or

securities for its own account, and it did not have an office in

the United States to which such income is attributable. 

Respondent contends that the income from non-U.S.

investments and term deposits is from sources within the United
- 144 -

States. Respondent contends that such income is effectively

connected income pursuant to the business-activities test because

the activities of LTD's U.S. business were a material factor in

the realization of the income. 

We have held, supra p. 108, that the income from non-U.S.

certificates of deposit and term deposits is characterized as

compensation for services and is treated as income from sources

within the United States. Accordingly, as petitioners’

effectively connected income argument presumes foreign source

income, we find that argument to have no merit.

LTD’s income from non-U.S. certificates of deposit and term

deposits is any "income, gain, or loss from sources within the

United States" not already described in the first two categories

of U.S. source income and, therefore, falls under the third

category of U.S. source income of a foreign corporation engaged

in the active conduct of a banking, financing, or similar

business. Sec. 1.864-4(c)(5)(vi)(b), Income Tax Regs. 

Accordingly, we analyze LTD’s income from non-U.S. certificates

of deposit and term deposits pursuant to either the asset-use or

business-activities test. Id. 

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business". Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s income from non-U.S.
- 145 -

certificates of deposit and term deposits consists of service

fees derived in the active conduct of a servicing business. 

Consequently, we apply the business-activities test to decide

whether such interest is effectively connected income. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment management portfolio exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

LTD’s income from non-U.S. certificates of deposit and term

deposits is effectively connected income, we must consider

whether "the activities of such trade or business were a material

factor in the realization of the income". Sec. 864(c)(2)(B). We

have held, supra p. 98, that LTD was engaged in "trade or

business within the United States" pursuant to section 864(b)

during its taxable years in issue. The activities of LTD’s trade

or business relating to its income from non-U.S. certificates of

deposit and term deposits included receiving clients’ funds,

depositing such funds in the client clearing account, either
- 146 -

purchasing a certificate of deposit from a non-U.S. bank or

placing the funds in a non-U.S. term deposits, and maintaining

records of LTD’s and its clients’ positions with respect to such

investments or deposits. We conclude that such activities of

LTD’s trade or business were "a material factor in the

realization of the income" within the meaning of section

864(c)(2)(B). We have given due regard to the question of

whether such income was accounted for through such trade or

business, and we find LTD’s income from non-U.S. certificates of

deposit and term deposits to have been accounted for through

LTD’s trade or business. Sec. 864(c)(2). Consequently, we hold

that LTD’s income from non-U.S. certificates of deposit and term

deposits is effectively connected income pursuant to section

1.864-4(c)(5)(vi)(b), Income Tax Regs., and section 864(c)(2)(B).

(3) Pace Investments

Petitioners contend that the Pace investments income is

income from sources outside the United States. Petitioners

contend that the Pace investments income is not effectively

connected income because it is not one of the types of foreign

source income which is deemed effectively connected income

pursuant to section 864(c)(4)(B) or (C). 

Respondent does not address the issue of whether the Pace

investment income is effectively connected.

We have held, supra p. 109, that the Pace investments income
- 147 -

is characterized as compensation for personal services and is

treated as income from sources within the United States. As

petitioners' effectively connected income argument presumes

foreign source income, we find that argument to have no merit.

LTD’s Pace investments income is any "income, gain, or loss

from sources within the United States" not already described in

the first two categories of U.S. source income and, therefore,

falls under the third category of U.S. source income of a foreign

corporation engaged in the active conduct of a banking,

financing, or similar business. Sec. 1.864-4(c)(5)(vi)(b),

Income Tax Regs. Accordingly, we analyze LTD’s Pace investment

income pursuant to either the asset-use or business-activities

test. Id.

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business". Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s Pace investments income

consists of service fees derived in the active conduct of a

servicing business. Consequently, we apply the businessactivities test to decide whether such fee is effectively

connected income.

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-
- 148 -

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment management portfolio exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

the Pace investments income is effectively connected income, we

must consider whether "the activities of such trade or business

were a material factor in the realization of the income". Sec.

864(c)(2)(B). We have held, supra p. 98, that LTD was engaged in

"trade or business within the United States" during its taxable

years in issue. The activities of LTD’s trade or business

relating to the Pace investments income included raising funds

from clients, depositing such funds with Mexican banks, and

arranging for clients to draw upon their unused lines of credit. 

We conclude that such activities of LTD’s trade or business were

"a material factor in the realization of the income" within the

meaning of section 864(c)(2)(B). We have given due regard to the

question of whether such income was accounted for through such

trade or business, and we find LTD's Pace investments income to

have been accounted for through LTD's trade or business. Sec.

864(c)(2). Consequently, we hold that LTD's Pace investments

income is effectively connected income pursuant to section 1.864-

4(c)(5)(vi)(b), Income Tax Regs., and section 864(c)(2)(B). 
- 149 -

c. Interest Income

(1) Loans

Petitioners contend that the loan interest is not

effectively connected income because the activities occurring in

INC's office were not the "material factor" underlying the

interest income. Petitioners argue that, because INC's only role

in handling the loans to clients was to note that a loan had been

extended and to record the rate agreed between the promoter and

client in Mexico, INC’s activities do not rise to the level of

conducting "a banking, financing, or similar business within the

United States" within the meaning of section 1.864-4(c)(5)(i),

Income Tax Regs.

Respondent contends that the interest from loans is interest

income from sources without the United States. Respondent

contends that such income is effectively connected income because

it falls under one of the types of foreign source income that is

deemed effectively connected pursuant to section

864(c)(4)(B)(ii). Additionally, respondent argues that the San

Antonio office was a material factor in the production of the

interest from loans. 

We have held, supra p. 110, that the loan interest is

characterized as interest income and is treated as income from

sources without the United States. Because petitioners’

effectively connected argument presumes U.S. source income, we

find that argument to have no merit. Additionally, we need not
- 150 -

address petitioners’ argument regarding INC because the proper

examination is with respect to LTD.

The loan interest is compensation for loans to LTD's clients

that LTD made in the active conduct of its trade or business in

the United States. Accordingly, the loan interest is "interest"

because it is "compensation for the use or forbearance of money." 

Deputy v. DuPont, 308 U.S. 488, 498 (1940). We have held, supra

p. 98, that LTD was "engaged in the active conduct of a banking,

financing, or similar business in the United States" within the

meaning of section 1.864-4(c)(5)(i), Income Tax Regs.

Consequently, we hold that LTD was "engaged in the active conduct

of a banking, financing, or similar business within the United

States" within the meaning of section 864(c)(4)(B)(ii). 

Accordingly, the loan interest is interest that is "derived in

the active conduct of a banking, financing, or similar business

within the United States" within the meaning of section

864(c)(4)(B)(ii).

The loan interest is "interest from sources without the

United States" other than interest from stocks or securities and,

therefore, falls under the third category of foreign source

income of a foreign corporation engaged in the active conduct of

a banking, financing, or similar business within the United

States. Sec. 1.864-6(b)(2)(ii)(d)(2), Income Tax Regs. 

Accordingly, in deciding whether such interest is effectively
- 151 -

connected income, we apply the requirements for dividends and

interest of a taxpayer not engaged in the active conduct of a

banking, financing, or similar business within the United States. 

Id. Accordingly, the loan interest is treated as effectively

connected if LTD has "an office or other fixed place of business

within the United States to which such income * * * is

attributable." Sec. 864(c)(4)(B); see sec. 1.864-6(b)(2)(ii)(a),

Income Tax Regs. 

The loan interest is attributable to LTD's office or fixed

place of business within the meaning of section 864(c)(4)(B)

because it satisfies the three tests articulated in section

864(c)(5) and the regulations thereunder. The first test

provides that the office of an agent shall be disregarded unless

the agent:

(i) has the authority to negotiate and conclude

contracts in the name of the nonresident alien

individual or foreign corporation and regularly

exercises that authority or has a stock of merchandise

from which he regularly fills orders on behalf of such

individual or foreign corporation, and (ii) is not a

general commission agent, broker, or other agent of

independent status acting in the ordinary course of his

business. * * * [Sec. 864(c)(5)(A)]

See also sec. 1.864-7(d)(1)(i), Income Tax Regs. As to clause

(i), during the years in issue, INC had the authority to

negotiate and to conclude contracts in LTD’s name and regularly

exercised such authority when it purchased the certificates of

deposit from banks on LTD’s behalf. As to clause (ii), we have

concluded, supra p. 67, that INC was not an "independent agent"
- 152 -

within the meaning of the section 1.864-7(d)(3)(i), Income Tax

Regs. Accordingly, INC's office shall not be disregarded in the

examination of whether LTD has an office or other fixed place of

business for purposes of section 864(c)(4)(B). We have held,

supra p. 79, with regard to the exclusion for trading in stocks

or securities pursuant to section 864(b)(2)(C) that LTD has "an

office or fixed place of business in the United States" within

the meaning of section 1.864-7, Income Tax Regs. Consequently,

we hold that LTD has "an office or other fixed place of business

in the United States" for purposes of section 864(c)(4)(B).

The second test provides that income, gain, or loss is not

to be considered as attributable to an office or fixed place of

business within the United States unless such office or fixed

place of business is a material factor in the production of such

income, gain, or loss. Sec. 864(c)(5)(B). The regulations

provide that loan interest meets the materiality test if it

satisfies either of the following alternative requirements:

the office or other fixed place of business either

actively participates in soliciting, negotiating, or

performing other activities required to arrange, the

issue, acquisition, sale, or exchange, of the asset

from which such income, gain, or loss is derived or

performs significant services incident to such issue,

acquisition, sale, or exchange. * * * [Sec. 1.864-

6(b)(2)(ii), Income Tax Regs.]

 

The San Antonio office meets both of the alternative

requirements. As to the first requirement, the office actively

arranged the loan from which the loan interest was derived by
- 153 -

verifying the availability of LTD’s funds and then transferring

such funds (usually by wire) to the borrowers, who were usually

clients. We view the second requirement as providing a less

stringent test than the first requirement because it provides

only that the office must perform "significant services incident"

to the transaction in issue. In the instant case, when the

office transferred the funds (usually by wire) to the borrowers

per their direction, we conclude that it effected the loans,

which was the performance of "significant services incident" to

such loans. Additionally, the office did not merely conduct the

four types of activities that do not cause an office to be

considered a material factor in the realization of income, gain,

or loss pursuant to section 1.864-6(b)(2)(ii)(a), Income Tax

Regs.; i.e., the San Antonio office did not merely (1) collect

the interest, (2) exercise general supervision over the

activities of the persons collecting the interest, (3) perform

merely clerical functions incident to the loan, or (4) exercise

final approval over the execution of the loan. Consequently, we

hold that the San Antonio office is a material factor in the

production of LTD’s loan interest within the meaning of section

864(c)(5)(B). 

The third test provides that "the income, gain, or loss

which shall be attributable to an office or other fixed place of

business within the United States shall be the income, gain, or

loss properly allocable thereto". Sec. 864(c)(5)(C). As the San
- 154 -

Antonio office is a material factor in the realization of the

loan interest for the taxable years in issue, such income is

considered to be allocable in its entirety to the San Antonio

office. Sec. 1.864-6(c)(1), Income Tax Regs.

Accordingly, because LTD satisfies the three tests regarding

its office or other fixed place of business, we conclude that its

foreign source loan interest is treated as effectively connected

income pursuant to section 1.864-6(b)(2)(ii)(d)(2), Income Tax

Regs., and section 864(c)(4)(B).

Nonetheless, any foreign source income deemed effectively

connected shall not be treated as effectively connected if such

income, assuming it were derived by the taxpayer from sources

within the United States for the taxable year, would not be

treated as effectively connected pursuant to the rules for U.S.

source income. Sec. 1.864-5(a), Income Tax Regs. Accordingly,

we must analyze whether LTD’s loan interest, if it were U.S.

source income, would be effectively connected income.

LTD’s loan interest, if U.S. source, would be any "income,

gain, or loss from sources within the United States" not already

described in the first two categories of U.S. source income and,

therefore, would fall under the third category of U.S. source

income of a foreign corporation engaged in the active conduct of

a banking, financing, or similar business. Sec. 1.864-

4(c)(5)(vi)(b), Income Tax Regs. Consequently, we analyze LTD’s

loan interest pursuant to either the asset-use or business-
- 155 -

activities test. Id. 

Section 1.864-4(c)(3)(i), Income Tax Regs., provides that

the business-activities test is of primary significance under

circumstances, inter alia, where "dividends or interest are

derived by a dealer in stocks or securities" but does not define

"a dealer in stocks or securities." However, section 1.864-

2(c)(2)(iv), Income Tax Regs., provides that "a dealer in stocks

or securities" is excepted from excluding trading activity from

the calculation of whether it is engaged in "trade or business

within the United States" pursuant to section 864(b); i.e., the

dealer must include trading activity in such calculation. We

have concluded, supra p. 85, with regard to the section

864(b)(2)(A)(ii) exclusion of trading for LTD’s trading for its

own account, that LTD is "a dealer in stocks or securities"

within the meaning of section 1.864-2(c)(2)(iv), Income Tax Regs. 

Because the two terms appear in the same Code section, we apply

the same definition to section 1.864-4(c)(3)(i), Income Tax Regs. 

Consequently, we hold that LTD is "a dealer in stocks or

securities" within the meaning of section 1.864-4(c)(3)(i),

Income Tax Regs. 

Accordingly, LTD’s interest from loans is interest derived

by a dealer of stocks or securities within the meaning of section

1.864-4(c)(3)(i), Income Tax Regs. Consequently, we apply the

business-activities test to decide whether such interest is

effectively connected income. 
- 156 -

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment portfolio management exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test. 

In applying the business-activities test to decide whether

the loan interest is effectively connected income, we must

consider whether "the activities of such trade or business were a

material factor in the realization of the income". Sec.

864(c)(2)(B). We have held, supra p. 98, that LTD was engaged in

"trade or business within the United States" pursuant to section

864(b) during its taxable years in issue. The activities of

LTD’s trade or business relating to the loan interest included

receiving clients’ funds, lending such funds to other clients,

collecting the interest and principal from the loans, and

maintaining records of LTD’s and the clients’ positions with

respect to such loans. We conclude that such activities of LTD’s

trade or business were "a material factor in the realization of

the income" within the meaning of section 864(c)(2)(B). We have

given due regard to the question of whether such income was

accounted for through such trade or business, and we find LTD’s
- 157 -

loan interest to have been accounted for through LTD’s trade or

business. Sec. 864(c)(2). Accordingly, we conclude that LTD’s

loan interest, if it were U.S. source, would be effectively

connected income pursuant to section 1.864-4(c)(5)(vi)(b), Income

Tax Regs., and section 864(c)(2)(B). Consequently, we hold that

LTD’s loan interest is effectively connected income pursuant to

section 1.864-6(b)(2)(ii)(d)(2), Income Tax Regs., and section

864(c)(4)(B). 

(2) MMA II

Petitioners contend that the MMA II interest is from sources

without the United States. Petitioners contend that such

interest is not effectively connected income because it is not

one of the types of foreign source income that is deemed

effectively connected income pursuant to section 864(c)(4)(B) or

(C).

Respondent contends that the MMA II interest from sources

without the United States. Respondent contends that such foreign

source interest is effectively connected income pursuant to

section 1.864-4(c)(5)(vi), Income Tax Regs. 

We have held, supra p. 110, that the MMA II income is

characterized as interest income and is treated as income from

sources without the United States. We believe that respondent

incorrectly relies on section 1.864-4(c)(5)(vi), Income Tax

Regs., which addresses U.S. source income. 
- 158 -

The MMA II interest is compensation for loans to Mexican

corporations that LTD made in the active conduct of its trade or

business in the United States. Accordingly, LTD's MMA II is

"interest" because it is "compensation for the use or forbearance

of money". Deputy v. DuPont, 308 U.S. at 498. We have held

supra p. 98, that LTD is "engaged in the active conduct of a

banking, financing, or similar business within the United States"

within the meaning of section 864(c)(4)(B)(ii). Accordingly, the

MMA II interest is "derived in the active conduct of a banking,

financing, or similar business within the United States" within

the meaning of section 864(c)(4)(B)(ii). 

The MMA II interest is "interest from sources without the

United States" other than interest from stocks and securities

and, therefore, falls under the third category of foreign source

income of a foreign corporation engaged in the active conduct of

a banking, financing, or similar business in the United States. 

Sec. 1.864-6(b)(2)(ii)(d)(2), Income Tax Regs. Accordingly, in

deciding whether such interest is effectively connected income,

we apply the requirements for dividends and interest of a

taxpayer not engaged in the active conduct of a banking,

financing, or similar business in the United States. Id.

Accordingly, the MMA II interest is treated as effectively

connected if LTD has "an office or other fixed place or business

within the United States to which such income * * * is
- 159 -

attributable". Sec. 864(c)(4)(B); see sec. 1.864-6(b)(2)(ii)(a),

Income Tax Regs. 

Based upon our analysis of the interest from loans, supra

pp. 142-145, and applying a similar analysis to the MMA II

interest, we hold that the MMA II interest satisfies the three

tests to be applied in deciding whether a taxpayer has "an office

or other fixed place of business within the United States to

which such income, gain, or loss is attributable" within the

meaning of section 864(c)(4)(B). Consequently, we conclude that

the MMA II income is effectively connected income pursuant to

section 1.864-6(b)(2)(ii)(d)(2), Income Tax Regs., and section

864(c)(4)(B). 

Nonetheless, any foreign source income deemed effectively

connected shall not be treated as effectively connected if such

income, assuming it were derived by the taxpayer from sources

within the United States for the taxable year, would not be

treated as effectively connected pursuant to the rules for U.S.

source income. Sec. 1.864-5(a), Income Tax Regs. Accordingly,

we must analyze whether LTD’s foreign source MMA II income, if it

were U.S. source income, would be effectively connected.

LTD’s MMA II interest, if U.S. source, would be any "income,

gain, or loss from sources within the United States" not already

described in the first two categories of U.S. source income and,

therefore, would fall under the third category of U.S. source
- 160 -

income of a foreign corporation engaged in the active conduct of

a banking, financing, or similar business. Sec. 1.864-

4(c)(5)(vi)(b), Income Tax Regs. Accordingly, we analyze LTD’s

MMA II interest pursuant to either the asset-use or businessactivities test. Id. 

We have held, supra pp. 146-147, that LTD is “a dealer in

stocks or securities” within the meaning of section 1.864-

4(c)(3)(i), Income Tax Regs. Accordingly, LTD’s MMA II interest

is interest derived by a dealer of stocks or securities within

the meaning of section 1.864-4(c)(3)(i), Income Tax Regs. 

Consequently, we apply the business-activities test to decide

whether such interest is effectively connected income. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment portfolio management exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

the MMA II interest is effectively connected income, we must

consider whether "the activities of such trade or business were a

material factor in the realization of the income". Sec.
- 161 -

864(c)(2)(B). We have held, supra p. 98, that LTD was engaged in

"trade or business within the United States" pursuant to section

864(b) during the taxable years in issue. The activities of

LTD’s trade or business relating to the MMA II interest included

receiving clients’ funds, lending such funds to other clients,

collecting the interest and principal from the loans, and

maintaining records of LTD’s and the clients’ positions with

respect to the loans. We conclude that such activities of LTD’s

trade or business were "a material factor in the realization of

the income" within the meaning of section 864(c)(2)(B). We have

given due regard to the question of whether such income was

accounted for through such trade or business, and we find LTD's

MMA II interest to have been accounted for through LTD's trade or

business. Sec. 864(c)(2). Accordingly, we conclude that LTD's

MMA II interest, if it were U.S. source, would be effectively

connected income pursuant to section 1.864-4(c)(5)(vi)(b), Income

Tax Regs., and section 864(c)(2)(B). Consequently, we hold that

LTD’s MMA II interest is effectively connected income pursuant to

section 1.864-6(b)(2)(ii)(d)(2), Income Tax Regs., and section

864(c)(4)(B).

d. Currency Exchange Transactions

Income (Currency Swaps

and Currency Transactions) 

Petitioners contend that the currency exchange transactions

income is from sources without the United States. Petitioners
- 162 -

contend that the income is not effectively connected income

because it is not one of the types of foreign source income that

is deemed effectively connected income pursuant to section

864(c)(4)(B) or (C). 

Respondent contends that the currency exchange transactions

income is, alternatively, (1) personal services income or (2)

gain from the sale of personal property. Respondent contends

that such income is effectively connected income pursuant to the

business-activities test because the activities of LTD's U.S.

business were a material factor in the realization of the income. 

We have held, supra pp. 111-112, that the currency exchange

transactions income is characterized as personal services income

and is treated as income in part from sources within the United

States and in part from sources without the United States. For

the portion of income which is foreign source, we agree with

petitioners that such income is not effectively connected income

because it is not one of the types of foreign source income that

is deemed effectively connected income pursuant to section

864(c)(4)(B) or (C). For the portion of income which is U.S.

source, we hold that such income is any "income, gain, or loss

from sources within the United States" not already described in

the first two categories of U.S. source income and, therefore,

falls under the third category of U.S. source income of a foreign

corporation engaged in the active conduct of a banking,
- 163 -

financing, or similar business. Sec. 1.864-4(c)(5)(vi)(b),

Income Tax Regs. Accordingly, we analyze LTD’s U.S. source

currency transactions income pursuant to either the asset-use or

business-activities test. Id. 

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business." Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s U.S. source currency

transactions income consists of service fees derived in the

active conduct of a servicing business. Consequently, we apply

the business-activities test to decide whether such income is

effectively connected income. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment portfolio management exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

the U.S. source currency transactions income is effectively

connected income, we must consider whether "the activities of

such trade or business were a material factor in the realization
- 164 -

of the income". Sec. 864(c)(2)(B). We have held, supra p. 98,

that LTD was engaged in "trade or business within the United

States" pursuant to section 864(b) during its taxable years in

issue. The activities of LTD’s trade or business relating to the

U.S. source currency transactions income included contacting

institutions for exchange rates and depositing or withdrawing

dollars or pesos. We conclude that such activities of LTD’s

trade or business were "a material factor in the realization of

the income" within the meaning of section 864(c)(2)(B). We have

given due regard to the question of whether such income was

accounted for through such trade or business, and we find LTD's

U.S. source currency transactions income to have been accounted

for through LTD's trade or business. Sec. 864(c)(2). 

Consequently, we hold that LTD's U.S. source currency

transactions income is effectively connected income pursuant to

section 1.864-4(c)(5)(vi)(b), Income Tax Regs., and section

864(c)(2)(B).

e. Sales Commissions and Fees

We examine all of LTD's income from commissions and fees

together, except for the foreign source TVA commissions, because

of the similarity of the services provided by LTD in earning such

commissions and fees. Petitioners and respondent provide similar

arguments for all of the commissions and fees, which are

summarized below. 
- 165 -

(1) Foreign Source TVA Commissions

Petitioners contend that the TVA commission is income from

sources outside the United States. Petitioners contend that such

commission is not effectively connected because it is not one of

the types of foreign source income that is deemed effectively

connected income pursuant to section 864(c)(4)(B) or (C). 

Respondent contends that the TVA commission is from sources

within the United States. Respondent contends that such

commission is effectively connected income through an implied

application of the business-activities test. 

We have held, supra pp. 116-117, that the TVA commission

consists of three types of income, two of which are foreign

source personal services income and one of which is U.S. source

personal services income. We agree with petitioners that the two

foreign source income items are not effectively connected income

because they do not fall under one of the types of foreign source

income that is deemed effectively connected income pursuant to

section 864(c)(4)(B) or (C). Consequently, we hold that those

two items are not subject to U.S. taxation. However,

petitioners’ argument, which presumes foreign source income, is

inapplicable to the TVA administration fee, which is

characterized as personal services income and which is treated as

income from sources within the United States. We analyze the

administration fee with all remaining LTD commissions and fees. 
- 166 -

(2) All Commissions and Fees Excepting

the Foreign Source TVA Commissions

Petitioners contend that the commissions and fees are income

from sources without the United States. Petitioners contend that

the commissions and fees are not effectively connected income

because they do not fall under one of the types of foreign source

income that is deemed effectively connected income pursuant to

section 864(c)(4)(B) or (C). 

Respondent contends that the commissions and fees are income

from sources within the United States. Respondent contends that

the commissions and fees are effectively connected income through

an implied application of the business-activities test. 

We have held, supra pp. 112-118, that all of the commissions

and fees, excepting the two types of foreign source TVA

commissions, are characterized as personal services income and

are treated as income from sources within the United States. 

Because petitioner's effectively connected income argument

presumes foreign source income, we find that argument to have no

merit. LTD’s commissions and fees (excepting the two types of

foreign source TVA commissions) are any "income, gain, or loss

from sources within the United States" not already described in

the first two categories of U.S. source income and, therefore,

fall under the third category of U.S. source income of a foreign

corporation engaged in the active conduct of a banking,

financing, or similar business. Sec. 1.864-4(c)(5)(vi)(b),
- 167 -

Income Tax Regs. Accordingly, we analyze LTD’s commissions and

fees pursuant to either the asset-use or business-activities

test. Id.

The business-activities test is of primary significance

under circumstances, inter alia, where "service fees are derived

in the active conduct of a servicing business". Sec. 1.864-

4(c)(3)(i), Income Tax Regs. LTD’s commissions and fees consist

of service fees derived in the active conduct of a servicing

business. Consequently, we apply the business-activities test to

decide whether such income is effectively connected. 

Before applying the business-activities test, however, we

must address the exception for activities relating to the

management of investment portfolios provided in section 1.864-

4(c)(3)(i), Income Tax Regs. We have held, supra pp. 130-131,

that the investment management portfolio exception is

inapplicable and, consequently, that LTD’s activities relating to

the management of investment portfolios shall be treated as

activities of LTD’s trade or business conducted in the United

States for purposes of applying the business-activities test.

In applying the business-activities test to decide whether

the commissions and fees are effectively connected income, we

must consider whether "the activities of such trade or business

were a material factor in the realization of the income". Sec.

864(c)(2)(B). We have held, supra p. 98, that LTD was engaged in

"trade or business within the United States" pursuant to section
- 168 -

864(b) during the taxable years in issue. We examine separately

the activities of LTD’s trade or business relating to each of the

commissions and fees. For the following reasons, we hold that in

each of the following commission or fee income categories, the

associated activities of LTD’s trade or business were a material

factor in the realization of such commission or fee: 

Currency Fund: LTD accepted clients’ deposits, opened an

account with a foreign bank, and issued periodic statements to

clients. 

FEIM Fund: LTD accepted clients’ deposits, transferred such

deposits to Merrill Lynch, and issued periodic statements to

clients. 

Matric Fund: LTD handled the paperwork and general

administration and distributed the interest payments to the

investors. 

Inversat Fund: LTD accepted clients' deposits, transferred

the funds from Inversat Fund to Inversat REIT, and provided

general investment management. 

TVA administration fee: LTD instructed INC to pay TVA a

monthly stipend to cover its development expenses and

administered the funds raised in the capital call itself.

Client incorporation and trust creation and legal advice

income: LTD counseled clients regarding the proper entity for

their investments and handled the paperwork, including arranging

legal services from third parties. 
- 169 -

Letters of credit: LTD sent the letters of credit, either

directly or indirectly through a bank, to Mexican banks in order

to secure loans for clients. 

Foreign exchange investments: LTD contacted institutions

for exchange rates and deposited or withdrew dollars or pesos per

the client's direction. 

Treasury bills: LTD arranged for the purchase of Treasury

bills through Merrill Lynch and other third party institutions. 

Wires and checks: LTD effected the wire and check

transactions. 

Gold and silver futures: LTD obtained rates and helped

effect the exchange transactions of gold and silver. 

Project income: LTD helped arrange the research project and

derived the income therefrom. 

Income from investments, other commissions income, other

commissions and fees, and other income: LTD performed the

services that earned LTD the income in such categories. 

We conclude that, for each commission or fee, excepting the

two types of foreign source TVA commissions, the activities of

LTD’s trade or business were "a material factor in the

realization of the income" within the meaning of section

864(c)(2)(B). We have given due regard to the question of

whether such income was accounted for through such trade or

business, and we find LTD's commissions and fees to have been

accounted for through LTD's trade or business. Sec. 864(c)(2). 
- 170 -

21

As we have noted, supra pp. 56-59, the parties stipulated

the amounts on which LTD is potentially liable for withholding

tax. Respondent argues that the withholding tax should be

imposed on "interest paid or credited to accounts of clients

which was earned on funds of clients pooled and invested in LTD’s

name." Based on facts disclosed by the record, we believe that

the interest listed as a "Special Accounts" expense consists of

interest paid by LTD to various other LTD accounts. Thus, the

interest paid to "Special Accounts" does not fall within

respondent’s withholding tax argument. Petitioners, however, did

not contest either the stipulation or respondent’s argument. 

Consequently, we will observe the parties’ stipulation and

(continued...)

Consequently, we hold that all of LTD's commissions and fees,

except the foreign source TVA commissions, are effectively

connected income pursuant to section 1.864-4(c)(5)(vi)(b), Income

Tax Regs., and section 864(c)(2)(B). 

C. Whether LTD and INC are Liable

for Withholding Tax 

1. Background

Respondent seeks to impose a withholding tax on three types

of income items paid by LTD to its clients. The first type of

income item, interest paid by LTD to its clients on investments

made in LTD’s name in U.S. certificates of deposit or bank

deposits, consists of interest paid on IFF and MMA investments

during the calendar years 1984 through 1989 (U.S. pooled

investments). The second type of income item, interest paid by

LTD to its clients from investments made in LTD’s name in foreign

banks, consists of interest paid on Asset Management Account,

Eurodeposits, InverCedes, InverCede2, Liquid Assets, Special

Accounts, Term Deposits, Pace, and MMA II investments21 during
- 171 -

21(...continued)

include the "Special Accounts" expense as an amount on which LTD

is potentially liable for withholding tax.

22

Petitioners do not argue that the interest is exempt from

(continued...)

the calendar years 1988 and 1989 (non-U.S. pooled investments). 

The third type of income, dividends, consists of a dividend paid

by LTD to its shareholders during the calendar years 1985 and

1986.

2. Withholding Tax on Interest

Withholding tax, which is imposed only on gross income items

from sources within the United States, is reported on a calendar

year basis. Sec. 1.1461-2(c), Income Tax Regs. Source rules for

interest, however, are generally applied based upon the obligor’s

taxable year. 

We first analyze the issue of who, in LTD’s pooled

investments program, is the obligor of the interest. Petitioners

argue that the obligor in LTD’s pooled investments program are

the U.S. and foreign banks from which LTD purchased the

investments. Petitioners, noting respondent’s concession that

the bank deposit exception to withholding tax applied to the

interest paid on certificates of deposit in the client’s name,

contend that there is no legal basis for distinguishing between

interest paid on certificates of deposit in the client's name and

interest paid on U.S. or foreign investments in LTD's name (the

pooled investments).22 Petitioners argue that all investments
- 172 -

22(...continued)

withholding tax as portfolio interest pursuant to secs. 871(h)

and 881(c). Consequently, we do not consider such argument.

made by LTD's clients were for their own account and risk and did

not establish a debtor-creditor relationship between LTD and its

clients or a shareholder-corporation relationship between the

clients and the pooled investment accounts. Petitioners contend

that, because the risk of loss always remained with the client,

the mere act of combining two or more clients' funds to purchase

a larger certificate of deposit did not create a "mutual fund".

Petitioners rely on Estate of Smith v. Commissioner, 33 T.C.

465 (1959). Petitioners argue that neither LTD nor INC was the

“obligor” of the interest earned in LTD’s name and paid to LTD’s

clients from pooled investments. Petitioners contend that the

relation among LTD/INC, the client, and any investment were the

same whether the investment was purchased in the client’s name

or, by pooling, in LTD’s name. Petitioners argue that the

interest "flowed through" INC and/or LTD and retained its

underlying character in the hands of LTD’s clients. Accordingly,

petitioners contend that, in the case of a pooled investment in a

U.S. certificate of deposit or bank deposit, the interest was

statutorily exempt from withholding, and, in the case of a pooled

investment in a non-U.S. certificate of deposit or term deposits,

the interest was foreign source, not subject to U.S. taxation of

any kind. 

Respondent, however, argues that the obligor in LTD’s pooled
- 173 -

investments program was LTD. Respondent argues that numerous

factors support such contention: The clients had no control over

how or where the money was invested; the money of all the clients

in all of the different LTD funds was pooled and invested in

LTD's name; LTD not only invested the pooled funds in

certificates of deposit but also used the pooled funds to make

loans to its clients and others, to use in special operations,

and to fund Inver Group's own investment projects; the rate of

return credited to the clients' accounts did not reflect the rate

of return earned by the investments because LTD received all of

the interest and paid the clients interest at a previously set

rate, retaining the benefit of the spread attributable to the

volume of the investments; LTD paid its clients interest,

regardless of whether or when LTD itself was paid; and LTD

credited interest to its clients, even though it had not yet

received the interest payment. 

Respondent contends that LTD was engaged in trade or

business in the United States. Accordingly, respondent argues

that, pursuant to the source rules for interest, the interest

paid by LTD as obligor was U.S. source income to LTD’s clients. 

Consequently, respondent contends that LTD is required to

withhold tax on the interest it paid to its clients. Respondent

contends that LTD is not "carrying on the banking business" for

purposes of the exemption for interest on deposits with persons

carrying on the banking business.
- 174 -

Additionally, respondent argues that INC had signatory

authority over the accounts in which funds were held, managed the

investments for the funds, and was responsible for crediting the

accounts of the clients from the funds. Accordingly, respondent

contends that INC controlled the payment of interest and is

therefore a withholding agent liable for withholding tax. 

In the instant case, we conclude that, in its pooled

investments program, LTD was not the obligor to its clients. We

have concluded, supra p. 96, that the "real business" of LTD was

to enable Mexican nationals to invest their capital in nonMexican financial markets. LTD’s clients did not place their

funds with LTD as an investment in LTD; rather, LTD’s clients

placed their funds with LTD as a manager, to be invested in nonMexican financial markets per the clients’ direction.

Respondent has conceded that the exemption for interest on

deposits with persons carrying on the banking business applies to

the interest paid on certificates of deposit in the clients’

name. We conclude that LTD’s relationship with its clients with

regard to pooled investments differs in no material respect from

its relationship with its clients with regard to investments

purchased in the client’s name. In both investment programs, LTD

had no economic interest in the pooled investments as such but

only an interest in the spread between the rates earned from the

investments and the rates paid by LTD to its clients. After

paying to its clients their respective portions of the interest
- 175 -

23

Sec. 1012(g)(1) of the Technical and Miscellaneous Revenue

Act of 1988, Pub. L. 100-647, 102 Stat. 3500, retroactively

provided the effective date of the Tax Reform Act of 1986 (1986

Act), Pub. L. 99-514, sec. 1214(c)(5), 100 Stat. 2543, as if

included in the 1986 Act.

earned on pooled investments, LTD retained only the spread that

it was able to negotiate. Accordingly, we conclude that, as to

its pooled investments program, LTD was not the obligor in its

relationship with its clients. 

Because we do not view LTD as the obligor, we treat the U.S.

and foreign banks as the obligors of the interest on pooled

investments paid by LTD to LTD’s clients. Additionally, we treat

the interest as retaining its underlying character in the hands

of LTD’s clients as interest from such U.S. and foreign banks. 

We turn next to whether LTD and INC are withholding agents

liable for withholding tax on the interest derived from U.S. and

foreign banks and paid by LTD/INC to LTD’s clients. The Tax

Reform Act of 1986 changed the statutory mechanism for exempting

from tax the interest earned on "deposits with persons carrying

on the banking business", effective for "payments made in a

taxable year of the payor beginning after December 31, 1986." 

Tax Reform Act of 1986 (1986 Act), Pub. L. 99-514, sec. 1214

(c)(5) and (d)(1), 100 Stat. 2543.23 

In the instant case, the interest from U.S. and foreign

banks was paid by LTD to its clients during the calendar years

1984 through 1989. Source rules for interest are generally
- 176 -

applied based upon the obligor’s taxable year. The parties,

however, did not present evidence regarding the taxable years of

the U.S. and foreign banks that paid the interest in issue. 

Nonetheless, our holdings, infra pp. 175-181, that the exemption

for interest on "deposits with persons carrying on the banking

business" applies in the instant case obviate the need to inquire

into the taxable years of the U.S. and foreign banks because

under both pre-1986 Act law and post-1986 Act law, the result is

the same: LTD and INC are not liable as withholding agents for

withholding tax. 

Post-1986 Act law applies to payments made in taxable years

of the U.S. and foreign banks beginning after December 31, 1986. 

We must therefore examine both regimes of law. 

a. Pre-1986 Act Law

(1) Character and Source

Rules for Interest 

Generally, the source of interest depends on the residence

of the obligor. Interest on bonds, notes, or other interestbearing obligations of U.S. residents, corporate or otherwise, is

generally treated as income from sources within the United

States. Sec. 861(a)(1). The term "resident of the United

States", used in section 1.861-2(a)(1), Income Tax Regs., which

was promulgated pursuant to section 861(a)(1), includes, inter

alia, "a foreign corporation or a foreign partnership, which at

any time during its taxable year is engaged in trade or business

in the United States." Sec. 1.861-2(a)(2)(iv), Income Tax Regs. 
- 177 -

Interest that is not treated as income from sources within

the United States pursuant to section 861(a)(1) is treated as

income from sources without the United States. Sec. 862(a)(1). 

Notwithstanding section 861(a)(1) and the regulations thereunder,

however, certain interest is treated as income from sources

without the United States. Sec. 1.861-2(b), Income Tax Regs. 

One type of interest that is not treated as income from sources

within the United States is interest that is received by a

nonresident alien individual or a foreign corporation on amounts

described in section 861(c), if such interest is not effectively

connected with the conduct of trade or business within the United

States. Sec. 861(a)(1)(A). The amounts described in section

861(c) include, inter alia, "deposits with persons carrying on

the banking business." Sec. 861(c)(1). 

The Code and the regulations do not define “deposits” for

purposes of section 861(c). The Commissioner, however, has

interpreted the term "deposits" to include, for purposes of

section 861(c), "time certificates of deposit, open account time

deposits, and multiple maturity time deposits, all of which are

interest bearing." Rev. Rul. 72-104, 1972-1 C.B. 209, 209.

The regulations provide that the phrase "persons carrying on

the banking business" includes, for purposes of section 861(c),

citizens of the United States or alien individuals and foreign or

domestic partnerships or corporations. Sec. 1.861-2(b)(1)(a),
- 178 -

24

Sec. 1.861-2(b)(1), Income Tax Regs., provides that the

interest on the deposits with persons carrying on the banking

business must be "paid or credited before January 1, 1977, to a

nonresident alien individual or foreign corporation". However,

sec. 1041 of the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat.

1634, repealed the last sentence of sec. 861(c), which had read: 

"Effective with respect to the amounts paid or credited after

December 31, 1976, subsection (a)(1)(A) and this subsection shall

cease to apply." Therefore, sec. 1.861-2(b)(1), Income Tax

Regs., applies to interest paid or credited to a nonresident

alien individual or foreign corporation after Dec. 31, 1976. 

Rev. Rul. 83-176, 1983-2 C.B. 111, 112. 

Income Tax Regs.24 The regulations, however, do not define

"carrying on the banking business". The Commissioner has applied

the section 581 definition of "bank" to interpret the phrase

"carrying on the banking business" for purposes of section

861(c). Rev. Rul. 83-176, 1983-2 C.B. 111, 112. Section 581

provides three requirements for an entity to be considered a

"bank" within the meaning of the statute. The first requirement

is that the entity must be "a bank or trust company incorporated

and doing business under the laws of the U.S. (including laws

relating to the District of Columbia) or of any State". Sec.

581. The second requirement is that a substantial part of the

entity's business must consist of "receiving deposits and making

loans and discounts, or of exercising fiduciary powers similar to

those permitted to national banks under the authority of the

Comptroller of the Currency." Id. The third requirement is that

the entity must be "subject by law to supervision and examination

by State * * * or Federal authority having supervision over

banking institutions." Id.
- 179 -

The Commissioner has ruled that the section 1.861-

2(b)(1)(i)(a), Income Tax Regs., definition of "persons" prevails

over the section 581 definition (the first requirement, supra),

which applies the term "bank" only to corporations. Rev. Rul.

83-176, 1983-2 C.B. at 112. The Commissioner, however, has ruled

that the "other language in section 581 relating to banking

activities can be used as an indication of the requirements

necessary to be considered engaged in the banking business." 

Id. In other words, the ruling requires the interest payor to

meet only the second and third requirements of the section 581

definition of "bank" in order to be considered "carrying on the

banking business" for purposes of section 861(c). 

(2) Taxation of Interest

Section 871(a)(1)(A) imposes on a nonresident alien

individual and section 881(a)(1) imposes on a foreign corporation

a tax of 30 percent of the amount of interest that is treated as

income from sources within the United States, if the interest is

not effectively connected income to the recipient. Interest that

is treated as income from sources without the United States is

not subject to tax pursuant to either section 871(a) or section

881(a).

Section 1441(a) provides that any person "having the

control, receipt, custody, disposal, or payment of any of the

items of income specified in * * * [section 1441](b) (to the
- 180 -

extent that any of such items constitutes gross income from

sources within the United States), of any nonresident alien

individual" must deduct and withhold from such income a tax of 30

percent of the amount of such income. Section 1442(a) applies a

withholding tax in the same manner as section 1441(a) on the

items of income of foreign corporations subject to taxation

pursuant to subtitle A. The income items specified in section

1441(b) include, inter alia, interest.

Section 1461 imposes liability for the tax due on every

person required to deduct and to withhold the tax imposed

pursuant to section 1441(a). However, interest that is treated

as income from sources without the United States is not subject

to withholding tax pursuant to section 1.1441-1, Income Tax

Regs., or, therefore, section 1.1442-1, Income Tax Regs. Sec.

1.1441-3(a), Income Tax Regs.

b. Post-1986 Act Law

(1) Character and Source Rules

for Interest 

Generally, the source of interest depends on the residence

of the obligor. With exceptions not applicable in the instant

cases, interest on bonds, notes, or other interest-bearing

obligations of noncorporate U.S. residents or U.S. corporations

is treated as income from sources within the United States. Sec.

861(a)(1). Interest that is not treated as income from sources

within the United States pursuant to section 861(a)(1) is treated
- 181 -

25

The Tax Reform Act of 1986, sec. 1241(b)(1)(A), 100 Stat.

2579, replaced the words "residents, corporate or otherwise" in

sec. 861(a)(1) with the words "noncorporate residents or domestic

corporations." The current sec. 861(a)(1), therefore, does not

refer to foreign corporations, which are instead covered pursuant

to sec. 884(f). Consequently, sec. 1.861-2(a)(2), Income Tax

Regs., issued pursuant to former sec. 861(a)(1), which treats

foreign corporations engaged in a U.S. trade or business at any

time during the taxable year as a U.S. resident for purposes of

the source rule, is irrelevant to years after sec. 861(a)(1) was

amended. The general rule, however, that the source of interest

depends on the residence of the obligor retains its validity. 

The regulations do not explicitly state that a corporation’s

"residence" is its place of incorporation, but sec. 861(a)(1)

does distinguish between "domestic" and "foreign" corporations

without reference, for example, to a "principal place of

business". Consequently, we conclude that the source of interest

depends on a corporation’s place of incorporation. 

as income from sources without the United States. Sec.

862(a)(1). Generally, interest from a foreign corporation is not

treated as income from sources within the United States pursuant

to section 861(a)(1)25 and is therefore treated as income from

sources without the United States. Sec. 862(a)(1). Section

884(f)(1)(A) provides special source rules for certain interest

paid by a foreign corporation engaged in trade or business in the

United States. 

(2) Taxation of Interest

Section 871(a)(1)(A) imposes on a nonresident alien

individual and section 881(a)(1) imposes on a foreign corporation

a tax of 30 percent of the amount of interest that is treated as

income from sources within the United States, if the interest is

not effectively connected income to the recipient. Interest that

is treated as income from sources without the United States is
- 182 -

not subject to tax pursuant to either section 871(a) or section

881(a).

Additionally, no tax is imposed pursuant to section

871(a)(1)(A) or section 881(a)(1) on any amount described in

section 871(i)(2). Secs. 871(i)(1), 881(d). The amounts

described in section 871(i)(2) include, inter alia, "Interest on

deposits, if such interest is not effectively connected with the

conduct of a trade or business within the United States." Sec.

871(i)(2)(A). Section 871(i)(3)(A) provides that, for purposes

of section 871(i)(2), the term "deposit" means, inter alia,

amounts that are "deposits with persons carrying on the banking

business". 

Section 1441(a) provides that any person "having the

control, receipt, custody, disposal, or payment of any of the

items of income specified in * * * [section 1441](b) (to the

extent that any of such items constitutes gross income from

sources within the United States), of any nonresident alien

individual" must deduct and withhold from such income a tax of 30

percent of the amount of such income. Section 1442(a) applies a

withholding tax in the same manner as section 1441(a) on the

items of income of foreign corporations subject to taxation

pursuant to subtitle A. The income items specified in section

1441(b) include, inter alia, interest.

Section 1461 imposes liability for the tax due on every

person required to deduct and to withhold the tax imposed
- 183 -

pursuant to section 1441(a). However, interest that is treated

as income from sources without the United States is not subject

to withholding tax pursuant to section 1.1441-1, Income Tax

Regs., or, therefore, section 1.1442-1, Income Tax Regs. Sec.

1.1441-3(a), Income Tax Regs. Additionally, no tax is required

to be deducted and withheld pursuant to section 1441(a) from any

amount described in section 871(i)(2). Secs. 1441(c)(10),

1442(a). 

3. Withholding Tax on Dividends

a. Character and Source Rules 

for Dividends 

Dividend payments made before December 31, 1986, will be

treated as income from sources within the United States if the

amount received as dividends is: 

from a foreign corporation unless less than 50 percent

of the gross income from all sources of such foreign

corporation for the 3-year period ending with the close

of its taxable year preceding the declaration of such

dividends (or for such part of such period as the

corporation has been in existence) was effectively

connected with the conduct of a trade or business

within the United States; but only in an amount which

bears the same ratio to such dividends as the gross

income of the corporation for such period which was

effectively connected with the conduct of a trade or

business within the United States bears to its gross

income from all sources * * * [Sec. 861(a)(2)(B).]

b. Taxation of Dividends

Section 871(a)(1) imposes on a nonresident alien individual

a tax of 30 percent of the amount of dividends treated as income

from sources within the United States, if the amount of dividends
- 184 -

is not effectively connected income to the recipient. Section

1441(a) provides that any person "having the control, receipt,

custody, disposal, or payment of any of the items of income

specified in * * * [section 1441](b) (to the extent that any of

such items constitutes gross income from sources within the

United States), of any nonresident alien individual" must deduct

and withhold from such income a tax of 30 percent of the amount

of such income. The income items specified in section 1441(b)

include, inter alia, dividends. Section 1461 imposes liability

for the tax due on every person required to deduct and to

withhold the tax imposed pursuant to section 1441(a).

Section 7701(a)(1) provides that the term "person" means and

includes "an individual, a trust, estate, partnership,

association, company or corporation." Sec. 7701(a)(16) provides

that the term "withholding agent" means "any person required to

deduct and withhold any tax under the provisions of section 1441,

1442, 1443, or 1461." The regulations promulgated pursuant to

section 1441 provide:

For purposes of chapter 3 of the Code, the term

"withholding agent" means any person who pays or causes

to be paid an item of income specified in § 1.1441-2 to

(or to the agent of) a nonresident alien individual, a

foreign partnership, a nonresident alien or foreign

fiduciary of a trust or estate, or a foreign

corporation, and who is required to withhold tax under

sections 1441, 1442, 1443, or 1451 from such item of

income. Any person who meets the definition of a

withholding agent is required to file the returns

prescribed by § 1.1461-1. * * * [Sec. 1.1441-7(a)(1),

Income Tax Regs.]
- 185 -

4. Discussion of Interest

a. Pre-1986 Act Years

(1) Application of the Character

and Source Rules for Interest

Petitioners argue that the interest received by LTD’s

clients is interest on deposits with persons carrying on the

banking business. Accordingly, petitioners argue that the

interest is income from sources without the United States. On

the other hand, respondent argues that the interest received by

LTD’s clients is paid by LTD as obligor and is therefore treated

as income from sources within the United States. 

We have concluded supra p. 165, that the interest paid to

LTD’s clients from pooled investments retains its character in

the hands of LTD’s clients. Because respondent’s source argument

presumes that LTD was the obligor of the interest, we find that

argument to have no merit.

As to the U.S. certificates of deposit and bank deposits

(the only pooled investments made by LTD during the pre-1986 Act

years), we conclude that the interest from such investments is

treated as income from sources without the United States. The

IFF and MMA investments consisted of certificates of deposit and

bank deposits with U.S. banks and were therefore "other interestbearing obligations of residents, corporate or otherwise" within

the meaning of section 861(a)(1) and the regulations thereunder. 

Consequently, the interest from such obligations is generally

treated as income from sources within the United States. Sec.

861(a)(1). 
- 186 -

26

A revenue ruling is entitled to no special deference. 

Higgins v. Commissioner, 312 U.S. 212, 215 (1941); Helvering v.

New York Trust, 292 U.S. 455 (1934); Stark v. Commissioner, 86

T.C. 243, 250-251 (1986). The Court of Appeals for the Fifth

Circuit has stated:

a [revenue] ruling is merely the opinion of a lawyer in

the agency and must be accepted as such. It may be

helpful in interpreting a statute, but it is not

binding on the Secretary [of the Treasury] or the

courts. It does not have the effect of a regulation or

a Treasury Decision. * * * [Stubbs, Overbeck &

Associates v. United States, 445 F.2d 1142, 1146-1147

(continued...)

Notwithstanding section 861(a)(1) and the regulations

thereunder, however, certain interest is treated as income from

sources without the United States. Sec. 1.861-2(b), Income Tax

Regs. Interest received by a nonresident alien individual or a

foreign corporation on "deposits with persons carrying on the

banking business" is not treated as income from sources within

the United States, if such interest is not effectively connected

with the conduct of trade or business within the United States. 

Sec. 861(a)(1)(A), (c)(1).

As we have stated supra p. 167, the Code and the regulations

do not define "deposits" for purposes of section 861(c). The

Commissioner, however, has interpreted the term "deposits" to

include, for purposes of section 861(c), "time certificates of

deposit, open account time deposits, and multiple maturity time

deposits, all of which are interest bearing." Rev. Rul. 72-104,

1972-1 C.B. 209, 209. We agree with the reasoning of Rev. Rul.

72-104, and we apply that reasoning in our interpretation of the

term "deposits" in section 861(c)(1).26 Accordingly, we conclude
- 187 -

26(...continued)

(5th Cir. 1971).]

 

Accordingly, a ruling or other interpretation by the Commissioner

is only as persuasive as the reasoning and precedents contained

in such interpretation. Halliburton Co. v. Commissioner, 100

T.C. 216, 232 (1993), and the cases cited therein, affd. without

published opinion 25 F.3d 1043 (5th Cir. 1994).

27

See supra note 26.

that the U.S. certificates of deposit and bank deposits are

"deposits" within the meaning of section 861(c).

As we have stated, supra pp. 168-169, neither the Internal

Revenue Code nor the relevant regulation defines the term

"carrying on the banking business" for purposes of section

861(c)(1). Rev. Rul. 83-176, 1983-2 C.B. 111, however,

interprets section 861(c). We agree with the reasoning of Rev.

Rul. 83-176, and we apply that reasoning in our interpretation of

the phrase "persons carrying on the banking business" in section

861(c)(1).27 

The parties did not brief the issue of whether the U.S.

banks from which LTD purchased pooled investments were "persons

carrying on the banking business" for purposes of section

861(c)(1). Based upon the entire record before us, however, we

are convinced that the banks were "persons carrying on the

banking business" within the meaning of section 861(c)(1). LTD

placed its clients’ funds in U.S. banks that were insured by the

FDIC and FSLIC. Accordingly, we conclude that all of the banks

with which LTD dealt meet the requirements that (1) a substantial

part of the person’s business consist of "receiving deposits and
- 188 -

making loans and discounts, or of exercising fiduciary powers

similar to those permitted to national banks under the authority

of the Comptroller of the Currency" and (2) the person must be

"subject by law to supervision and examination by State, or

Federal authority having supervision over banking institutions." 

Rev. Rul. 83-176, 1983-2 C.B. at 112. Consequently, we conclude

that the U.S. banks that paid interest on LTD’s pooled

investments are "persons carrying on the banking business" within

the meaning of section 861(c)(1). Accordingly, we hold that the

interest from the U.S. pooled investments is treated as income

from sources without the United States. Sec. 861(a)(1)(A),

(c)(1).

(2) Taxation of Interest

We have held, supra, the interest paid to LTD’s clients on

the U.S. pooled investments is treated as income from sources

without the United States. Sec. 861(a)(1)(A), (c)(1). Interest

that is treated as income from sources without the United States

is not subject to tax pursuant to either section 871(a) or

section 881(a). Additionally, interest that is treated as income

from sources without the United States is not subject to

withholding tax pursuant to either section 1.1441-1, Income Tax

Regs., or, therefore, section 1.1442-1, Income Tax Regs. Sec.

1.1441-3(a), Income Tax Regs. Consequently, we hold that neither

LTD nor INC is a withholding agent liable for withholding tax

with respect to the interest paid on pooled investments during

the pre-1986 Act years.
- 189 -

b. Post-1986 Act Years

(1) Application of the Character

and Source Rules for Interest

Petitioners argue that the interest received by LTD’s

clients retained its underlying character. Accordingly,

petitioners argue that the interest from U.S. pooled investments

received by LTD's clients is income from sources within the

United States and that the interest from non-U.S. pooled

investments is income from sources without the United States. On

the other hand, respondent argues that the interest received by

LTD’s clients is paid by LTD as obligor and is therefore treated

as income from sources within the United States pursuant to

section 884(f)(1)(A).

We have concluded, supra p. 165, that the interest paid to

LTD’s clients from pooled investments retains its character in

the hands of LTD’s clients. Because respondent’s source argument

presumes that LTD was the obligor of the interest, we find that

argument to have no merit. 

As to the U.S. pooled investments, we conclude that the

interest from such investments is treated as income from sources

within the United States. The interest from the IFF and MMA

investments derived from certificates of deposit and bank

deposits with U.S. banks, which are "other interest-bearing

obligations of * * * domestic corporations" within the meaning of

section 861(a)(1). Accordingly, we hold that the interest from

the U.S. pooled investments is treated as income from sources

within the United States. Sec. 861(a)(1).
- 190 -

As to the non-U.S. pooled investments, we conclude that the

interest from such investments is treated as income from sources

without the United States. The Asset Management Account,

Eurodeposits, InverCedes, InverCede2, Liquid Assets, Special

Accounts, Term Deposits, Pace, and MMA II investments consisted

of certificates of deposit and term deposits with non-U.S. banks. 

The interest on such investments, therefore, derived from nonU.S. obligors. Accordingly, we hold that the interest from the

non-U.S. pooled investments is treated as income from sources

without the United States. Sec. 862(a)(1). 

(2) Taxation of Interest

As we have stated, supra pp. 171-172, section 871(a)(1)(A)

imposes on a nonresident alien individual and section 881(a)(1)

imposes on a foreign corporation a tax of 30 percent of the

amount of interest that is treated as income from sources within

the United States, if the interest is not effectively connected

income to the recipient. No tax, however, is imposed pursuant to

section 871(a)(1)(A) or section 881(a)(1) on interest on deposits

with persons carrying on the banking business. Secs. 871(i)(1),

881(d). 

As to the U.S. pooled investments, we apply an analysis

similar to the one for the pre-1986 Act years, supra pp. 177-178,

and conclude that the U.S. banks that paid interest on LTD’s

pooled investments are "persons carrying on the banking business"

for purposes of section 871(i)(3)(A). Accordingly, we hold that
- 191 -

the interest from the U.S. pooled investments is interest on

"deposits with persons carrying on the banking business" within

the meaning of section 871(i)(2)(A) and (3)(A). Consequently, no

tax is imposed on the interest from the U.S. pooled investments

paid by LTD to its clients. Secs. 871(i)(1), 881(d). 

Additionally, no tax is required to be deducted and withheld

pursuant to section 1441(a) from any amount described in section

871(i)(2). Secs. 1441(c)(10), 1442(a).

As to the non-U.S. certificates of deposit and term

deposits, we have concluded, supra p. 180, that the interest from

such investments is treated as income from sources without the

United States. Interest that is treated as income from sources

without the United States is not subject to tax pursuant to

either section 871(a) or section 881(a). Additionally, interest

that is treated as income from sources without the United States

is not subject to withholding tax pursuant to either section

1.1441-1, Income Tax Regs., or, therefore, section 1.1442-1,

Income Tax Regs. Sec. 1.1441-3(a), Income Tax Regs. 

Consequently, we hold that neither LTD nor INC is a withholding

agent liable for withholding tax with respect to the interest

paid on pooled investments during the post-1986 Act years.

5. Discussion of Dividend Income

Petitioners contend that they have shown that none of LTD's

worldwide gross income was effectively connected and that,

because less than 50 percent of LTD's worldwide gross income was
- 192 -

effectively connected, the section 861(a)(2)(B) source rule does

not apply to the dividend paid by LTD to its shareholders. 

Alternatively, petitioners contend that, should we find that LTD

had some effectively connected income during its 3 taxable years

prior to the taxable year ended June 30, 1986, less than 50

percent of LTD’s gross income was effectively connected, and the

dividend therefore would be foreign source and not subject to

withholding tax. As a final alternative, petitioners contend

that, should we find that LTD's effectively connected income

exceeded the 50-percent threshold of section 861(a)(2)(B), only

the portion of LTD's dividend that is proportionate to LTD's

percentage of effectively connected income in such years should

be treated as U.S. source income.

Respondent argues that LTD is a withholding agent liable for

withholding tax on the entire amount of the dividend. Respondent

contends that all of LTD's income was effectively connected with

its U.S. trade or business. Accordingly, respondent argues that

the entire dividend paid by LTD is U.S. source income pursuant to

section 861(a)(2)(B) and is therefore subject to withholding tax

pursuant to section 1441(a). 

In the instant case, the dividend in issue was declared on

December 10, 1985. In applying section 861(a)(2)(B), we must

look to LTD’s worldwide gross income for the 3 taxable years that

ended prior to the declaration of the dividend in issue; i.e.,

LTD’s taxable years ended June 30, 1983 through 1985. 

Petitioners did not present evidence regarding LTD’s taxable
- 193 -

years ended June 30, 1983 and 1984. We are therefore unable to

apply the lookback rule in section 861(a)(2)(B) to the dividend

in issue. Consequently, we consider the percentage figure in

section 861(a)(2)(B) to have been conceded by petitioners. Rybak

v. Commissioner, 91 T.C. 524, 566 (1988). Accordingly, we hold

that 100 percent of LTD’s gross income from all sources for the

3-year period ending with the close of its taxable year preceding

the declaration of the dividend in issue was effectively

connected with the conduct of LTD’s trade or business within the

United States. Sec. 861(a)(2)(B).

Because more than 50 percent of LTD's gross income was

effectively connected for the applicable 3-year period, the

amount of the dividend in issue that is to be treated as from

sources within the United States bears the same ratio to such

dividend as the amount of effectively connected income bears to

gross income from all sources. Id. The ratio that LTD’s

effectively connected income bears to LTD’s gross income from all

sources is, for purposes of section 861(a)(2)(B), 100 percent. 

Accordingly, the amount of the dividend in issue that is to be

treated as from sources within the United States is 100 percent. 

Id. The entire dividend paid by LTD to its shareholders is

therefore subject to a 30-percent tax on nonresident alien

individuals. Sec. 871(a). 

The parties have not briefed the issue of whether LTD is

eligible for the withholding exemption pursuant to section
- 194 -

1441(c), and they have not addressed whether LTD’s shareholders

were engaged in trade or business within the United States. 

Accordingly, we treat the issue as having been conceded by

petitioners. Rybak v. Commissioner, supra at 566. Because LTD

is not eligible for exemption from withholding pursuant to

section 1441(c), LTD is a withholding agent pursuant to sections

1441(a) and 7701(a)(16) and therefore must pay a 30-percent tax

on the dividend. 

D. Whether LTD Is Entitled to Deductions

1. Law

A foreign corporation engaged in trade or business within

the United States during the taxable year is allowed deductions

from its section 882(a) income "only if and to the extent that

such deductions are connected with income which is effectively

connected with the conduct of a trade or business within the

United States". Sec. 882(c)(1)(A). The proper apportionment and

allocation of such deductions are determined as provided in

regulations prescribed by the Secretary. Id.

A foreign corporation receives the benefit of such

deductions "only by filing or causing to be filed with the

Secretary a true and accurate return, in the manner prescribed in

subtitle F, including therein all the information which the

Secretary may deem necessary for the calculation of such

deductions". Sec. 882(c)(2); see also sec. 1.882-4(b)(1), Income

Tax Regs. If a true and accurate return is not filed, "the tax
- 195 -

shall be collected on the basis of gross income, determined in

accordance with §1.882-1 but without regard to any deductions

otherwise allocable." Sec. 1.882-4(b)(2), Income Tax Regs. 

2. Discussion

Petitioners note that regulations promulgated pursuant to

section 882(c)(2), as amended in 1990, requiring a "timely filed

tax return" before a foreign taxpayer is allowed to offset

effectively connected income with deductions allocable thereto,

are effective for taxable years ended after July 31, 1990, and

therefore that such regulations post-date all of the years in

issue. Additionally, petitioners contend that the prior version

of such regulations did not contain similar language requiring

that a tax return be timely filed as a precondition to deducting

items properly allocable to effectively connected income. 

However, as indicated supra, the prior version of the

regulations, which is applicable here, did provide that a foreign

corporation would not be allowed such deductions unless it filed

a true and accurate return. In the instant cases, LTD has filed

no return at all and therefore has failed to comply with the

express requirement of the applicable regulations. 

Respondent, citing Blenheim Co. v. Commissioner, 125 F.2d

906, 911 (4th Cir. 1942), affg. 42 B.T.A. 1248 (1940), and

Georday Enters., Ltd. v. Commissioner, 126 F.2d 384, 388 (4th

Cir. 1942), affg. an unpublished opinion of the Board of Tax

Appeals dated Sept. 30, 1940, contends that, because LTD filed no
- 196 -

returns, it is not entitled to any deductions. Respondent

contends that LTD should be denied the deduction for interest

paid to clients. Respondent argues that interest paid or accrued

on indebtedness is characterized as a deduction by the Code and

that a deduction for interest should therefore be denied. 

Respondent contends that, as the interest was recorded on LTD's

corporate books as an expense, respondent's treatment of the

interest is consistent with LTD's own records. Additionally,

respondent contends that LTD should be denied all other

deductions. 

In the instant case, we must examine four types of

"deductions": (1) the interest "deductions" included as a direct

cost in LTD's "Interest Income" category, (2) the direct costs in

all of LTD's income categories other than "Interest Income", (3)

compensation expenses for the fees already paid by LTD to INC,

and (4) additional compensation expenses potentially allocated to

LTD pursuant to section 482. As to the interest "deductions"

included as a direct cost in LTD's "Interest Income" category, we

have concluded, supra p. 106, that LTD should include in its

income only the amounts that it retained as interest spreads from

certificates of deposit and bank deposits. Accordingly, as the

interest paid by LTD to its clients on pooled investments is

neither income nor a deduction to LTD, we need not address such

amounts. As to the additional compensation expenses potentially

allocated to LTD pursuant to section 482, we address such
- 197 -

28

Sec. 233 of the Revenue Act was the predecessor statute to

sec. 882(c)(2) of both 1954 I.R.C. and 1986 I.R.C. 

amounts, infra pp. 215-220.

We conclude that, because LTD filed no returns, it is not

entitled to any deductions for the direct costs in all of LTD's

income categories other than "Interest Income" or for

compensation expenses for the fees already paid by LTD to INC. 

In Blenheim Co. v. Commissioner, supra, the taxpayer, a foreign

corporation, filed a personal holding company surtax return (Form

1120H) but not an income tax return (Form 1120). The

Commissioner's "Extended efforts * * * to get * * * [the

taxpayer] to file a Form 1120 return voluntarily were

unsuccessful", and the Commissioner was "forced by * * * [the

taxpayer's] inactivity and uncooperative attitude to prepare a

return for * * * [the taxpayer]". Id. at 909. In the return

that the Commissioner prepared for the taxpayer, the Commissioner

disallowed deductions and credits pursuant to section 233 of the

Revenue Act of 1934.28 The Commissioner then sent a notice of

deficiency to the taxpayer based on that return. Id. 

The taxpayer then filed an income tax return (Form 1120)

that included "a breakdown of petitioner's income and claimed

deductions." Id. The Board of Tax Appeals held that the

circumstances of the case warranted the disallowance of the

deductions. The Court of Appeals for the Fourth Circuit

affirmed, stating that
- 198 -

Without prescribing an absolute and rigid rule

that whenever the Commissioner files a return for a

foreign corporation the taxpayer is completely and

automatically denied the benefit of deductions or

credits, we yet hold that the facts of the instant case

justify a disallowance of deductions which petitioner

might otherwise have been entitled to claim, had it

filed a timely return in compliance with the statutory

requirement. * * * [Id. at 910.]

In Georday Enters., Ltd. v. Commissioner, supra at 388, a

companion case to Blenheim, the Court of Appeals for the Fourth

Circuit stated that "our decision in the Blenheim case is

determinative" on the issue, inter alia, of "the timeliness of

Georday's federal income tax return". The court then stated:

The case for disallowance of Georday's deductions is

even stronger here because Georday failed to file a

return voluntarily not only after a return had been

filed for it by the Commissioner and after a deficiency

letter had been sent to it, but even after a petition

to the Board had been filed. * * * [Id.]

The court held that "Georday, therefore, clearly failed to file

its return within the reasonable terminal period prescribed in

the Blenheim case and is now precluded from obtaining the

benefits of any deductions it might have otherwise been entitled

to claim had it filed a timely return." Id. 

In the instant cases, LTD had not filed income tax returns

for the taxable years in issue as of the date of trial of the

instant cases. We therefore uphold respondent’s disallowance of

any deductions that LTD might have otherwise been entitled to

claim had it filed a timely, true, and accurate return pursuant

to section 882(c)(2).
- 199 -

29

For INC's taxable years ended June 30, 1987, 1988, and 1989,

INC was joined in the consolidated income tax returns filed by

Holdings. Accordingly, respondent's income allocations to INC

pursuant to sec. 482 affect the income tax liability of Holdings. 

For convenience and clarity, we make reference to INC only and

include Holdings in such references.

E. Whether Income Should Be Allocated

Pursuant to Section 482 

1. Background

By notices of deficiency, respondent determined that income

should be allocated to INC and Holdings pursuant to section 482. 

As to INC’s taxable years ended June 30, 1985 and 1986,

respondent determined by notice of deficiency that INC had

received other income and attached as an exhibit to the notice of

deficiency a list of the balances in three bank accounts. 

Respondent treated the sum of the balances from the three

accounts as income to INC for each taxable year. Respondent

never amended the income allocations as to INC’s taxable years

ended June 30, 1985 and 1986.

As to Holdings’ taxable years ended June 30, 1987, 1988, and

1989, respondent determined by notice of deficiency that Holdings

had received other income.29 Respondent allocated to INC all of

LTD’s remaining net income. Respondent calculated LTD’s

remaining net income by deducting LTD’s "direct costs" and LTD’s

payment of service fees to INC from LTD’s gross receipts. 

Respondent never amended the income allocations as to INC’s

taxable years ended June 30, 1987, 1988, and 1989. 
- 200 -

30

Sec. 482 provides as follows: 

In any case of two or more organizations, trades,

or businesses (whether or not incorporated, whether or

not organized in the United States and whether or not

affiliated) owned or controlled directly or indirectly

by the same interests, the Secretary may distribute,

apportion, or allocate gross income, deductions,

credits, or allowances between or among such

organizations, trades, or businesses, if he determines

that such distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxes or

clearly to reflect the income of any of such

organizations, trades, or businesses.

The amendment to sec. 482 by 1986 Act sec. 1231(e)(1), 100

Stat 2562, regarding the transfer of intangible property does not

affect the instant case. 

2. Law

a. Section 482 in General

Section 48230 provides the Commissioner with broad authority

to allocate income, deductions, credits, or allowances between

commonly controlled organizations, trades, or businesses if

respondent determines that the reallocation is necessary to

prevent the evasion of taxes or clearly to reflect the income of

any of the controlled entities. 

The purpose of section 482 is "to place a controlled

taxpayer on a tax parity with an uncontrolled taxpayer, by

determining, according to the standard of an uncontrolled

taxpayer, the true taxable income from the property and business

of a controlled taxpayer." Sec. 1.482-1(b)(1), Income Tax Regs. 

Stated another way, the purpose of section 482 is to prevent the

artificial shifting of the net incomes of controlled taxpayers by
- 201 -

placing controlled taxpayers on a parity with uncontrolled,

unrelated taxpayers. Seagate Technology, Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 163 (1994), and the cases cited

therein. 

The regulations promulgated pursuant to section 482 provide: 

The interests controlling a group of controlled

taxpayers are assumed to have complete power to cause

each controlled taxpayer so to conduct its affairs that

its transactions and accounting records truly reflect

the taxable income from the property and business of

each of the controlled taxpayers. If however, this has

not been done, and the taxable incomes are thereby

understated, the district director shall intervene,

and, by making such distributions, apportionments, or

allocations as he may deem necessary of gross income,

deductions, credits, or allowances, or of any item or

element affecting taxable income, between or among the

controlled taxpayers constituting the group, shall

determine the true taxable income of each controlled

taxpayer. * * * [Sec. 1.482-1(b)(1), Income Tax

Regs.]

The term "true taxable income" means,

in the case of a controlled taxpayer, the taxable

income (or, as the case may be, any item or element

affecting taxable income) which would have resulted to

the controlled taxpayer, had it in the conduct of its

affairs (or, as the case may be, in the particular

contract, transaction, arrangement, or other act) dealt

with the other member or members of the group at arm’s

length. * * * [Sec. 1.482-1(a)(6), Income Tax Regs.] 

The true taxable income of the group as a whole, as well as

its individual members, must be accurately determined. See

Schering Corp. & Subs. v. Commissioner, 69 T.C. 579, 600 (1978),

and the case cited therein. Accordingly, each controlled

taxpayer will be examined independently to determine whether each

such individual taxpayer is reporting its own true taxable
- 202 -

income; i.e., the taxable income (or item or element affecting

taxable income) that would have resulted to such taxpayer in an

arm’s-length transaction. See Altama Delta Corp. v.

Commissioner, 104 T.C. 424, 456 (1995); Seagate Tech., Inc. &

Consol. Subs. v. Commissioner, supra at 164; Sundstrand Corp. v.

Commissioner, 96 T.C. 226, 353 (1991), affd. 17 F.3d 965 (7th

Cir. 1994). Once the true taxable income of each controlled

taxpayer is determined, the Commissioner may distribute,

apportion, or allocate gross income, deductions, credits, or

allowances, or any item or element affecting taxable income, so

that each controlled taxpayer, after such an allocation, reports

its own true taxable income. 

The Commissioner's determination as set forth in a notice of

deficiency is presumptively correct. The taxpayer has the burden

of proof. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). 

Moreover, absent a showing of abuse of discretion by the

Commissioner, the Commissioner's section 482 determination must

be sustained. Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525,

582 (1989), affd. 933 F.2d 1084 (2d Cir. 1991). To succeed,

therefore, a taxpayer first must show that the Commissioner's

section 482 reallocations are arbitrary, capricious, or

unreasonable. Sundstrand Corp. v. Commissioner, supra; Eli Lilly

& Co. v. Commissioner, 84 T.C. 996, 1131 (1985), affd. in part,

revd. in part and remanded 856 F.2d 855 (7th Cir. 1988). In
- 203 -

deciding whether the Commissioner's determination is reasonable,

courts focus on the reasonableness of the result, not on the

details of the methodology used. Bausch & Lomb, Inc. v.

Commissioner, supra at 582; see also Eli Lilly & Co. v. United

States, 178 Ct. Cl. 666, 676, 372 F.2d 990, 997 (1967). 

Once the taxpayer has proved that the deficiencies set forth

in the notice of deficiency are arbitrary, capricious, or

unreasonable, the taxpayer has the additional burden of proving

satisfaction of the arm's length standard. See Eli Lilly & Co.

v. Commissioner, 856 F.2d at 860; Sundstrand Corp. v.

Commissioner, supra at 354. 

In the instant case, as between LTD and INC, respondent's

allocations at least must be reasonable attempts to reflect arm's

length transactions. See Achiro v. Commissioner, 77 T.C. 881,

900 (1981). 

b. The Section 482 Regulations

The term "controlled" is defined as including "any kind of

control, direct or indirect, whether legally enforceable, and

however exercisable or exercised." Sec. 1.482-1(a)(3), Income

Tax Regs. The term "controlled taxpayer" means "any one of two

or more organizations, trades, or businesses owned or controlled

directly or indirectly by the same interests." Sec. 1.482-

1(a)(4), Income Tax Regs. The terms "group" and "group of

controlled taxpayers" mean "the organizations, trades, or

businesses owned or controlled by the same interests." Sec.
- 204 -

1.482-1(a)(5), Income Tax Regs. 

The regulations provide:

Where one member of a group of controlled entities

performs marketing, managerial, administrative,

technical, or other services for the benefit of, or on

behalf of another member of the group without charge or

at a charge which is not equal to an arm’s-length

charge * * * , the district director may make

appropriate allocations to reflect an arm’s-length

charge for such services. * * * [Sec. 1.482-2(b)(1),

Income Tax Regs.]

The regulations provide a "benefit test", stating that

"Allocations may be made to reflect arm’s length charges with

respect to services undertaken for the joint benefit of the

members of a group of controlled entities, as well as with

respect to services performed by one member of the group

exclusively for the benefit of another member of the group." 

Sec. 1.482-2(b)(2)(i), Income Tax Regs. Conversely, "No

allocations shall be made if the probable benefits to the other

members were so indirect or remote that unrelated parties would

not have charged for such services." Id.

An arm’s-length charge for services rendered is "the amount

which was charged or would have been charged for the same or

similar services in independent transactions with or between

unrelated parties under similar circumstances considering all

relevant facts." Sec. 1.482-2(b)(3), Income Tax Regs. Unless

the services are an integral part of the business activity of

either the entity rendering the services (renderer) or the entity

receiving them (recipient), or unless the taxpayer establishes a
- 205 -

more appropriate charge, the arm's length charge for services is

deemed to equal the cost or deductions incurred with respect to

the services performed by the renderer for the recipient. Id. 

For services which are an integral part of the business

activity of either the renderer or the recipient, the costs or

deductions incurred in rendering such services are not deemed to

equal an arm’s-length charge. Sec. 1.482-2(b)(7), Income Tax

Regs. Services are considered an integral part of the business

activity of a related entity in four situations. The situation

applicable to the instant case is the second situation, defined

as a case in which "the renderer renders services to one or more

related parties as one of its principal activities." Sec. 1.482-

2(b)(7)(ii), Income Tax Regs. The regulations provide two tests

for determining the applicability of the second situation. The

first test (the 25-percent test) is stated as follows: 

it will be presumed that the renderer does not render

services to related parties as one of its principal

activities if the cost of services of the renderer

attributable to the rendition of services for the

taxable year to related parties do not exceed 25

percent of the total costs or deductions of the

renderer for the taxable year. * * * [Sec. 1.482-

2(b)(7)(ii)(a), Income Tax Regs.]

 

Pursuant to the 25-percent test, the costs of services

rendered to related parties include "all costs or deductions

directly or indirectly related to the rendition of such services"

but excludes "amounts properly reflected in the cost of goods

sold of the renderer." Sec. 1.482-2(b)(7)(ii)(b), Income Tax

Regs. Additionally, the regulations provide that, in a case:
- 206 -

Where any of the costs or deductions of the renderer do

not reflect arm's length consideration and no

adjustment has been made under any provision of the

Internal Revenue Code to reflect arm's length

consideration, the 25-percent test will not apply if,

had an arm’s-length charge been made, the costs or

deductions attributable to the renderer's rendition of

services to related entities would exceed 25 percent of

the total costs or deductions of the renderer for the

taxable year. * * * [Id.]

 

Once the 25-percent test is satisfied, the regulations

provide a second test, which is a determination of whether the

rendition of services to related parties is one of the principal

activities of the renderer, based "on the facts and circumstances

of each particular case" (the facts and circumstances test). 

Sec. 1.482-2(b)(7)(ii)(a), Income Tax Regs. Factors which may be

considered in the facts and circumstances test include: 

the time devoted to the rendition of the services, the

relative cost of the services, the regularity with

which the services are rendered, the amount of capital

investment, the risk of loss involved, and whether the

services are in the nature of supporting services or

independent of the other activities of the renderer. 

* * * [Id.]

Pursuant to section 482:

the method of allocating, apportioning, or distributing

income, deductions, credits, and allowances to be used

by the district director, in any case, including the

form of the adjustments and the character and source of

amounts allocated, shall be determined with reference

to the substance of the particular transactions or

arrangements which result in the avoidance of taxes or

the failure to clearly reflect income. * * * [Sec.

1.482-1(d)(1), Income Tax Regs.]

The appropriate adjustments may take the form of, inter alia, an

increase or decrease in gross income, or an increase or decrease

in deductions (including depreciation). Id. 
- 207 -

Section 1.482-1(d)(2), Income Tax Regs., provides:

Whenever the district director makes adjustments

to the income of one member of a group of controlled

taxpayers (such adjustments being referred to in this

paragraph as "primary" adjustments) he shall also make

appropriate correlative adjustments to the income of

any other member of the group involved in the

allocation. The correlative adjustment shall actually

be made if the United States income tax liability of

the other member would be affected for any pending

taxable year. Thus, if the district director makes an

allocation of income, he shall not only increase the

income of one member of the group, but shall decrease

the income of the other member if such adjustment would

have an effect on the United States income tax

liability of the other member for any pending taxable

year. * * * 

A "pending taxable year" is "any taxable year with respect to

which the United States income tax return of the other member has

been filed by the time the allocation [the primary adjustment] is

made, and with respect to which a credit or refund is not barred

by the operation of any law or rule of law." Id. For purposes

of paragraph (d) of section 1.482-1, Income Tax Regs., the

regulations state that a primary adjustment:

shall not be considered to have been made (and

therefore a correlative adjustment is not required to

be made) until the first occurring of the following

events with respect to the primary adjustment: 

(i) The date of assessment of the tax following

execution by the taxpayer of a Form 870 (Waiver of

Restrictions on Assessment and Collection of Deficiency in

Tax and Acceptance of Overassessment) with respect to such 

adjustment,

(ii) Acceptance of a Form 870-AD (Offer of Waiver of

Restriction on Assessment and Collection of Deficiency in 

Tax and Acceptance of Overassessment),

(iii) Payment of the deficiency,

(iv) Stipulation in the Tax Court of the United States,

or

(v) Final determination of tax liability by offer-incompromise, closing agreement, or court action. * * * [Id.]
- 208 -

3. Discussion

Petitioners contend that an arm’s-length fee was charged by

INC for its investment management services rendered to LTD. 

Petitioners contend that the fee was arm's length because

petitioners used a "cost-plus [profit]" calculation in the early

years. During 1986, INC began charging a fee based on "an assets

under management percentage." As support for the contention that

the fee was arm's length, petitioners emphasize that

representatives from both INC and LTD negotiated the fee in

consultation with outside counsel and that the fee was reviewed

and accepted each year by the companies' outside auditor. 

Petitioners contend that INC's fees were comparable to the

fees that United States Trust charged LTD before the creation of

INC. Petitioners contend that United States Trust is "an

independent service provider" which charged an arm’s-length fee

for its services.

Finally, petitioners contend that respondent's section 482

allocations are arbitrary, capricious, and unreasonable on the

following additional grounds. Petitioners assert that

respondent's expert report is flawed. Petitioners contend that

conclusions of respondent's experts about INC's operations had no

relation to the facts. Furthermore, petitioners complain that

respondent has allocated all of LTD's remaining net income to

INC. Petitioners contend that, for respondent's allocations to

prevail, all of the income LTD earned in the taxable years ended

1985 through 1989 must have "originated exclusively through INC
- 209 -

personnel working in San Antonio." Petitioners assert that there

were only a handful of management-level employees working in

INC’s office in San Antonio, and that there was a relatively low

level of activity in that office, as evidenced by the low number

of telephone calls from that office to Mexico. Petitioners

contend that the income received by LTD from structuring and

executing currency transactions and from the TVA underwriting was

not generated from San Antonio by INC personnel. 

Respondent contends that INC provided LTD with much more

than "back office services". Respondent argues that numerous

services were provided to LTD by INC: (1) INC provided all of

the services that LTD was obligated to provide to the third party

clients, (2) INC generated the spreads from U.S. and foreign

pooled investments by obtaining higher interest rates on

investments than those paid to clients, (3) account executives at

INC were the primary point of contact and information source for

financial transactions involving clients and promoters, (4)

account executives at INC maintained Account Cards on which they

recorded instructions that they received directly from clients

over the telephone and in person in the San Antonio office, (5)

INC employees implemented the clients' investment decisions,

monitored the clients' investments, acted as an interface between

clients and other financial institutions concerning currency

exchanges, money transfers, loans, and securities, and provided

current information to clients and promoters concerning various

investment products, (6) INC made all investment decisions on
- 210 -

behalf of LTD, (7) INC's Operations Department researched and

chose investment vehicles for the omnibus IFF and MMA funds, and

(8) INC's personnel tracked exchange rates for the currency

futures and brokerage services LTD offered. 

Respondent contends that LTD's service agreements with its

clients (the discretionary authorizations) were, for the most

part, independent transactions between unrelated parties. 

Respondent argues that, because INC performed all of its services

on behalf of LTD, the revenues of LTD are the best indicators of

what INC's arm's length charges to LTD should have been, which is

the reason respondent allocated all of the remaining net revenues

earned by LTD to INC. Accordingly, respondent argues that the

arm's length charge for investment management services INC

provided to LTD was the net amount of revenues LTD derived in

servicing its clients. Accordingly, respondent argues that

allocations should be made to INC pursuant to section 482 as

follows:

 INC’s Reported Respondent's 

Year Revenues from LTD Allocations 

1985 $582,000 $444,345

1986 945,000 960,206

1987 1,281,000 916,865

1988 1,440,000 1,027,586

1989 1,830,000 4,217,333

Finally, respondent contends that LTD is not entitled to the

deduction correlating to respondent's section 482 allocation to

INC. 
- 211 -

31

We have previously noted that "sec. 1.482-2(b)(1), Income

Tax Regs., applies to a group of controlled 'entities' while sec.

(continued...)

We first examine whether INC is a controlled taxpayer within

the meaning of section 1.482-1(a)(4), Income Tax Regs. INC was a 

wholly owned subsidiary of LTD, directly, during the taxable

years ended June 30, 1985 and 1986, and indirectly, through the

insertion of a holding company, Holdings, during the subsequent

taxable years in issue. Consequently, we conclude that LTD

controlled INC within the meaning of section 1.482-1(a)(3),

Income Tax Regs., and that INC is a controlled taxpayer within

the meaning of section 1.482-1(a)(4), Income Tax Regs. 

Additionally, because the same interests that own LTD also own

INC, we conclude that LTD and INC constitute a "group of

controlled taxpayers" within the meaning of section 1.482-

1(a)(5), Income Tax Regs. 

We turn next to whether INC provides the required services

pursuant to section 1.482-2(b)(1), Income Tax Regs. INC provides

administrative services to LTD. INC handles the daily operations

of LTD’s pooled investments program and its funds, performs

research and bookkeeping, and produces the monthly client

statements. INC and LTD are each members of a group of

controlled entities. Consequently, INC provides administrative

or other services for the benefit of another member of the group

of controlled entities within the meaning of section 1.482-

2(b)(1), Income Tax Regs.31 
- 212 -

31(...continued)

1.482-1(b)(1), Income Tax Regs., describing the scope and purpose

of sec. 482, refers to a group of controlled 'taxpayers.' We

believe that the difference in language is insignificant." Haag

v. Commissioner, 88 T.C. 604, 622 n.13 (1987), affd. without

published opinion 855 F.2d 855 (8th Cir. 1988). LTD and INC are

thus both "controlled entities" and "controlled taxpayers", and

income may properly be allocated to INC to reflect arm's length

dealing pursuant to sec. 482.

We turn next to whether INC passes the benefit test of

section 1.482-2(b)(2)(i), Income Tax Regs. The regulations

provide that allocations may be made to reflect arm’s length

charges "with respect to services performed by one member of the

group exclusively for the benefit of another member of the

group." Sec. 1.482-2(b)(2)(i), Income Tax Regs. INC rendered

services exclusively for the benefit of LTD, which constituted,

in actuality, rendering services to LTD's clients. The benefits

to LTD were not so indirect or remote that unrelated parties

would not have charged for such services. Id. LTD paid INC an

annual fee for the services that INC rendered for LTD’s benefit. 

Accordingly, we hold that INC passes the benefit test of section

1.482-2(b)(2)(i), Income Tax Regs. 

We must next ascertain whether the services are an integral

part of the business activity of either the entity rendering the

services (renderer) or the entity receiving them (recipient)

pursuant to section 1.482-2(b)(3), Income Tax Regs., in order to

decide which regime to apply in determining INC’s arm's length

charge for its services. In their briefs, the parties did not

apply the two tests of section 1.482-2(b)(7)(ii), Income Tax
- 213 -

Regs. As to the 25-percent test, the cost of services of INC

attributable to its rendition of services to LTD can be

extrapolated from the proportion of INC's revenues earned from

LTD to INC's total revenues. In the taxable year ended 1985,

with gross revenues of $618,190, INC reported $582,000 of revenue

from LTD, or 94.1 percent of its gross revenues from LTD. In the

taxable year ended 1986, with gross revenues of $953,583, INC

reported $945,000 of revenue from LTD, or 99.1 percent of its

revenue from LTD. In the taxable year ended 1987, with gross

revenues of $1,395,545, INC reported $1,281,000 of revenue from

LTD, or 91.8 percent of its gross revenues from LTD. In the

taxable year ended 1988, with gross revenues of $1,532,579, INC

reported $1,440,000 of revenue from LTD, or 94.0 percent of its

gross revenues from LTD. In the taxable year ended 1989, with

gross revenues of $1,909,563, INC reported $1,830,000 of revenue

from LTD, or 95.8 percent of its gross revenues from LTD. 

Assuming that INC's revenues attributable to its rendition of

services for the taxable year to LTD, when expressed as a

percentage of INC's gross revenues, are commensurate with the

costs of services INC provides for LTD, we conclude that INC

meets the 25-percent floor in each taxable year ended 1985

through 1989. 

Once the 25-percent test is satisfied, the regulations

provide a second test, which is a determination of whether the

rendition of services to related parties is one of the principal

activities of the renderer based on a facts and circumstances
- 214 -

test. Sec. 1.482-2(b)(7)(ii)(a), Income Tax Regs. Factors which

may be considered in such determination include:

the time devoted to the rendition of the services *

* * [to related parties], the relative cost of the

services, the regularity with which the services are

rendered, the amount of capital investment, the risk of

loss involved, and whether the services are in the

nature of supporting services or independent of the

other activities of the renderer. * * * [Id.]

 

The regulations do not define a "related party" for purposes

of section 1.482-2(b)(7)(ii)(a), Income Tax Regs. INC and LTD,

however, are members of a group of controlled entities within the

meaning of section 1.482-2(b)(1), Income Tax Regs., and INC is a

wholly owned subsidiary of LTD. Consequently, we believe that

INC and LTD are "related parties" within the meaning of section

1.482-2(b)(7)(ii)(a), Income Tax Regs. 

In the instant cases, nearly all of INC's activities were

devoted to the rendition of services to a related party, LTD. 

INC rendered services to LTD, which constituted, in reality, the

rendering of services to LTD's clients. INC researched the

financial institutions and interest rates for the certificate of

deposit operation. Additionally, INC regularly rendered services

to LTD. INC performed the day-to-day functions for the

certificate of deposit operation, which included placing the

funds as directed by the clients and collecting interest and

dividends at the proper maturity, depositing such items into the

client’s account or LTD’s accounts, and reinvesting funds if

necessary. 
- 215 -

The relative cost of the services that INC provided to LTD

is unknown, but, based upon the fact that greater than 90 percent

of INC's gross revenues came from LTD, see supra pp. 202-203, the

cost of services INC provided to LTD similarly must be relatively

large in amount. The exact amount of capital investment made by

INC with regard to rendering services to LTD is unknown. INC

did, however, establish an office in San Antonio to perform its

duties. INC’s tax returns for the years in issue show that INC

purchased an office copier, computer equipment and software, and

office equipment and furniture. In sum, INC’s capital investment

with regard to rendering services to LTD appears to have been

relatively large in amount. 

The risk of loss involved in the rendition of services by

INC to LTD appears to have been relatively low. After the end of

each of the taxable years ended June 30, 1985, 1986, and 1987,

INC finalized with LTD the total amount of payments to be paid by

LTD to INC for services rendered during the preceding taxable

year. INC had a relatively low risk of loss in the rendition of

services to LTD.

The services that INC rendered to LTD were in the nature of

supporting services. INC provided administrative services that

supported LTD’s investment management business. INC’s rendition

of services did not constitute a manufacturing, production,

extraction, or construction activity. The regulations analyze

the type of services rendered--i.e., whether or not they are
- 216 -

supporting services--to determine whether the 25-percent test

applies. Sec. 1.482-2(b)(7)(v), Example (8), Income Tax Regs. 

We find that the services that INC rendered were in the nature of

supporting services for purposes of section 1.482-2(b)(7)(ii),

Income Tax Regs.

The factor of whether the services that INC rendered to LTD

were independent of the other activities of INC is not applicable

to the instant case. INC performed very few, if any, "other"

activities that were not for LTD. Consequently, the services

that INC rendered to LTD cannot be viewed as "independent" of the

"other activities" of INC because INC had few "other activities". 

Accordingly, we believe that the factor of "independent" services

is not relevant to the instant cases. 

Based on the foregoing, we conclude that, pursuant to the

facts and circumstances test, INC renders services to a related

party as one of its principal activities within the meaning of

section 1.482-2(b)(7)(ii)(a), Income Tax Regs. Consequently, we

hold that the services are an integral part of the business

activity of INC within the meaning of section 1.482-2(b)(7),

Income Tax Regs. Because services are an integral part of INC's

business activity, an arm’s-length charge for INC's services

rendered to LTD is "the amount which was charged or would have

been charged for the same or similar services in independent

transactions with or between unrelated parties under similar

circumstances considering all relevant facts." Sec. 1.482-

2(b)(3), Income Tax Regs. 
- 217 -

In deciding whether the Commissioner's determination is

reasonable, courts focus on the reasonableness of the result and

not on the details of the methodology used. Bausch & Lomb, Inc.

v. Commissioner, 92 T.C. 525 (1989); see also Eli Lilly & Co. v.

United States, 178 Ct. Cl. at 676, 372 F.2d at 997. In the

instant cases, we hold that respondent's determinations are

unreasonable because of the lack of reasonableness in the

results. That is, we conclude that (1) as to INC’s taxable years

ended June 30, 1985 and 1986, the allocation of the sum of three

bank accounts as income to INC is arbitrary, and (2) as to INC’s

taxable years ended June 30, 1987, 1988, and 1989, the allocation

of the remaining amount of LTD’s net income to INC (thereby

effecting an allocation, when added to the amount of service fees

already paid by LTD to INC, of all of LTD’s net income to INC) is

arbitrary. See Achiro v. Commissioner, 77 T.C. at 990. We reach

this conclusion because respondent, in the notices of deficiency,

failed to trace which activities of INC earned what revenue and

failed to distinguish income earned by LTD from income earned by

INC. 

Nonetheless, once petitioners prove that the deficiencies

set forth in the notice of deficiency are arbitrary, capricious,

or unreasonable, they still have the burden of proving that their

own allocation satisfies the arm's length standard. If they fail

to carry the latter burden, the court must determine the proper

allocation of items based upon the record. See Eli Lilly & Co.
- 218 -

32

We note that the record reveals instances in which LTD dealt

with "related" or favored clients who were charged lower or no

fees. For unrelated clients, however, LTD charged a standard

amount for the transactions it effectuated.

v. Commissioner, 856 F.2d at 860; Sundstrand Corp. v.

Commissioner, 96 T.C. at 354.

Petitioners argue that, in the instant case, arm’s-length

charges are: (1) The amounts charged by INC to LTD, (2) the

amounts charged by United States Trust to LTD, or (3) the amounts

petitioners' expert has concluded would have been charged for

similar services under similar circumstances. Respondent argues

that arm’s-length charges are: (1) The amounts charged by LTD to

its clients, or (2) LTD's net revenues, determined by

respondent's experts to approximate what would have been charged

for similar services under similar circumstances. 

In the instant cases, we conclude that the amounts which

were charged in independent transactions for the same services

are arm's length charges. The record in the instant cases

provides arm's length charges for the services in issue because

LTD charged its unrelated clients for the services LTD paid INC

to perform.32 Both parties’ experts provided their opinions as

to an arm’s-length charge. We, however, conclude that such

estimates are not useful in light of the facts and circumstances

of the instant cases. Additionally, we conclude that the amounts

charged by INC to LTD are not, by definition, arm's-length

charges because they do not derive from independent transactions
- 219 -

between unrelated parties. Finally, we conclude that the amounts

charged by United States Trust are not useful because they derive

from years prior to those in issue and do not address, by

definition, the pooled investments and funds LTD arranged for its

clients.

The services in issue were marketed by LTD to the public. 

LTD, however, did not actually perform the services but instead

paid INC to perform them. In other words, the services

"rendered" by LTD were the same services INC performed for LTD's

clients on behalf of LTD. Consequently, because the fees that

LTD charged its unrelated clients were an "amount which was

charged or would have been charged for the same or similar

services in independent transactions with or between unrelated

parties under similar circumstances considering all relevant

factors", we conclude that such fees represent an arm’s-length

charge within the meaning of section 1.482-2(b)(3), Income Tax

Regs. 

We turn now to our calculation of the arm’s length charges

for the services that LTD paid INC to perform. The parties did

not specifically brief what services were to be considered in the

section 482 allocation. In deciding INC’s true taxable income

from service fees, we limit our examination and holding to the

same investment products that we have discussed, supra pp. 29-56,

with regard to LTD’s income and expenses. We note that, in such

discussion, the "Direct Costs" for each category of income did
- 220 -

not include LTD’s payment of service fees to INC. Consequently,

we held, supra pp. 206-207, that respondent’s allocation of the

remaining amount of LTD’s net income to INC (thereby effecting an

allocation, when added to the amount of service fees already paid

by LTD to INC, of all of LTD’s net income to INC) is arbitrary. 

Because we use the fees that LTD charged its unrelated

clients as the arm’s length charge for INC’s services, we

calculate INC’s arm’s length charge in the same manner as LTD

calculated its service charges to its clients; to wit: we

multiply the net value of assets placed with LTD by a percentage

factor, depending upon the category of investment. As to the

total amounts of client assets placed with LTD, we use the

figures in respondent's expert report, which are rounded from

figures in the audited annual reports of LTD and its subsidiaries

for 1985 through 1989. As to the percentage factors, which for

some products include an initial placement cost and an asset

management fee, we use the figures in the discretionary

authorizations or the Deloitte workpapers.

LTD paid INC to handle LTD’s certificates of deposit and

pooled investments operation, cash and investment funds, and

Treasury bill transactions. LTD charged its clients 0.50 percent

of the net assets placed with LTD in the certificate of deposit

operation, cash and investment funds, or Treasury bill

transactions. Accordingly, the arm’s length charge for INC’s

services for such operations is the amount of net assets received

from clients times 0.50 percent. 
- 221 -

LTD paid INC to maintain investments placed in the Currency

Fund. LTD charged its clients a 3-percent placement cost plus an

annual management fee, starting with the second year, of 1.00

percent of the value of the assets under management. 

Accordingly, the arm’s length charge for INC’s services for that

operation is the amount of clients’ newly placed net assets times

3 percent plus the amount of clients’ already placed net assets

times 1.00 percent.

LTD paid INC to maintain investments placed in the FEIM

Fund. LTD charged its clients a placement cost based on a

sliding scale of 4.00 percent to 0.25 percent, depending upon the

amount of the investment. LTD also charged an annual management

fee, starting with the second year, of 1.00 percent of the value

of the assets under management. Petitioners did not present

evidence on and the record does not reveal the precise amounts of

clients’ funds at each level of the graduated placement costs. 

Consequently, we are unable to calculate LTD’s FEIM Fund

commission on a sliding scale. We note that Deloitte used in its

audit a figure of 3.00 percent, and we apply that amount in the

instant case. Accordingly, the arm’s length charge for INC’s

services for that operation is the amount of clients’ newly

placed net assets times 3.00 percent plus the amount of clients’

already placed net assets times 1.00 percent.

LTD paid INC to maintain investments placed in the Inversat

Fund. LTD charged its clients a placement cost based on a

sliding scale of 3.50 percent to 0.25 percent, depending upon the
- 222 -

amount of the investment. LTD also charged an annual management

fee, starting with the second year, of 1.00 percent of the value

of the assets under management. Petitioners did not present

evidence on and the record does not reveal the precise amounts of

clients’ funds at each level of the graduated placement costs. 

Consequently, we are unable to calculate LTD’s Inversat Fund

commission on a sliding scale. We note that Deloitte used in its

audit a figure of 3.00 percent, and we apply that amount in the

instant case. Accordingly, the arm’s length charge for INC’s

services for such operation is the amount of clients’ newly

placed net assets times 3.00 percent plus the amount of clients’

already placed net assets times 1.00 percent. 

LTD paid INC to maintain investments placed in the Matric

Fund. LTD charged its client, Matric Corp., a consulting fee of

$47,500 to maintain the Matric Fund. Accordingly, the arm’s

length charge for INC’s services for that operation is $47,500.

LTD paid INC to maintain investments placed in TVA. LTD

charged its client, TVA, Inc., an administration fee of $5,000

per month. Accordingly, the arm’s length charge for INC’s

services for that operation is $5,000 per month.

LTD paid INC to effect currency transactions. The amount

that LTD earned is the amount that LTD charged its clients. Some

of LTD’s income, however, was generated by LTD’s Guadalajara

office and not by INC. Consequently, INC will not be allocated

that income. Accordingly, the arm’s length charge for INC’s
- 223 -

33

For LTD’s taxable year ended June 30, 1987, its revenues

from currency transactions totaled $434,867, of which $11,361 was

earned by the Guadalajara office. Accordingly, we calculate

INC’s arm’s length charge for the services that it rendered as

$423,506. 

For LTD’s taxable year ended June 30, 1988, its revenues

from currency transactions totaled $232,426, of which $16,426 was

earned by the Guadalajara office. Accordingly, we calculate

INC’s arm’s length charge for the services that it rendered as

$216,000. 

services for those operations is the amount of LTD’s revenues

minus the amounts earned by the Guadalajara office.33 

LTD paid INC to perform services for other funds,

operations, and transactions. The amount that LTD earned is the

amount that LTD charged its clients. Accordingly, the arm’s

length charge for INC’s services for such operations is the

amount of LTD’s revenues.

We calculate the arm's length charges for INC's services as

follows: 

TYE June 30, 1985

Certificates of deposit 70,175,000 x 0.50%= $350,875

Cash & investment funds 10,274,000 x 0.50%= 51,370

Treasury bills 1,482,000 x 0.50%= 7,410

Currency transactions LTD’s revenues= 531,003

Currency swaps LTD’s revenues= 54,386

Total 995,044

TYE June 30, 1986

Certificates of deposit 100,180,000 x 0.50%= 500,900

Cash & investment funds 19,199,000 x 0.50%= 95,995

Treasury bills 3,355,000 x 0.50%= 16,775
- 224 -

Currency fund commissions

Placement cost 4,090,000 x 3.00%= 122,700

FEIM fund commissions 

Placement cost 5,872,000 x 3.00%= 176,160

Currency transactions LTD’s revenues= 745,001

Client incorporation and

trust creation fees LTD’s revenues= 169,263

Total 1,826,794

TYE June 30, 1987

Certificates of deposit 106,468,000 x 0.50%= 532,340

Cash & investment funds 17,284,000 x 0.50%= 86,420

Treasury bills 1,887,000 x 0.50%= 9,435

Currency fund commissions

Placement cost 8,608,000 x 3.00%= 258,240

Management fee 4,090,000 x 1.00%= 40,900

FEIM fund commissions 

Placement cost 2,152,000 x 3.00%= 64,560

Management fee 5,872,000 x 1.00%= 58,720

Inversat fund commissions

Placement cost 2,780,000 x 3.00%= 83,400

TVA administration fees LTD's revenues= 15,000

Currency transactions income LTD’s revenues= 423,506

Client incorporation and

trust creation fees LTD’s revenues= 363,014

Letters of credit fees LTD’s revenues= 6,866

 Total 1,942,401

TYE June 30, 1988

Certificates of deposit 152,671,000 x 0.50%= 763,355

Cash & investment funds 99,590,000 x 0.50%= 497,950

Currency fund commissions
- 225 -

Placement cost 0 x 3.00%= - 0 - 

Management fee 11,404,000 x 1.00%= 114,040

FEIM fund commissions

Placement cost 0 x 3.00%= - 0 - 

Management fee 6,400,000 x 1.00%= 64,000

Inversat fund commissions

Placement cost 0 x 3.00%= - 0 -

Management fee 2,729,000 x 1.00%= 27,290

Wire and check fees LTD’s revenues= 13,274

Currency transactions income LTD’s revenues= 216,000

Client incorporation and

trust creation fees LTD’s revenues= 290,518

TVA administration fees LTD’s revenues= 60,000

Gold and silver fees LTD’s revenues= 14,110

Letters of credit fees LTD’s revenues= 91,556

Total 2,152,093

1989

Certificates of deposit

and term deposits 111,268,000 x 0.50%= 556,340

Cash & investment funds 110,966,000 x 0.50%= 554,830

Currency fund commissions

Placement cost 0 x 3.00%= - 0 -

Management fee 4,927,000 x 1.00%= 49,270

FEIM fund commissions

Placement cost 1,278,000 x 3.00%= 38,340

Management fee 6,400,000 x 1.00%= 64,000

Inversat fund commissions

Placement cost 0 x 3.00%= - 0 -

Management fee 2,729,000 x 1.00%= 27,290

Matric fund commissions LTD’s revenues= 47,500
- 226 -

34

As we have stated supra note 3, LTD’s deficiencies in income

tax for its taxable years ended June 30, 1985 and 1986, are not

at issue in the instant case. Accordingly, we decide whether LTD

is entitled to a correlative adjustment for each of its taxable

years ended June 30, 1987, 1988, and 1989.

Wire and check fees LTD’s revenues= 26,360

Client incorporation and

trust creation fees LTD’s revenues= 404,286

TVA administration fees LTD’s revenues= 60,000

Gold and silver fees LTD’s revenues= 60,112

Letters of credit fees LTD’s revenues= 53,047

Total 1,941,375

As LTD paid service fees to INC during the years in issue, the

amount of income to be allocated to INC is the difference between

(1) the arm's-length charges calculated supra and (2) the amounts

of service fees already paid. Accordingly, we hold that income

is to be allocated to INC from LTD pursuant to section 482 for

INC's taxable years ended June 30, 1985 through 1989.

Once a primary adjustment is made to INC's income, the

district director is required to make a correlative adjustment to

the income of LTD pursuant to section 1.482-1(d)(2), Income Tax

Regs. The parties have briefed the issue of whether LTD is

entitled to such correlative adjustment.34 

The primary adjustment to INC’s income is not considered to

have been made until the occurrence of the first of any of the

five events set forth in section 1.482-1(d)(2), Income Tax Regs. 

The event relevant to the instant case is a final determination
- 227 -

of tax liability by court action. A correlative adjustment is

not required to be made until a primary adjustment is made. Sec.

1.482-1(d)(2), Income Tax Regs. As the primary adjustment is not

considered to have been made until a final determination of tax

liability by court action, a correlative adjustment is also not

required to be made until that time. Accordingly, as a final

determination of tax liability by court action will not occur

until after the issuance of this opinion, the correlative

adjustment is not required to be made until after issuance of

this opinion. The record, however, contains all facts necessary

to decide, at this point, whether LTD is entitled to a

correlative adjustment.

Petitioners contend that "As a matter of law, if not simple

logic, should the * * * [Tax] Court reallocate any amount of

LTD’s income to INC, then LTD’s taxable income should be reduced

in equal amount." Petitioners cite the correlative adjustment

provisions of section 1.482-1(d)(2), Income Tax Regs., as support

for the treatment of any section 482 allocation of income to INC

as a deduction to LTD. Petitioners note that denying the

deduction of the section 482 correlative adjustment to LTD

results in taxing the same dollar twice: once in the hands of

LTD and once in the hands of INC. 

Respondent agrees that LTD would ordinarily be entitled to a

correlative adjustment equal to the primary adjustment to INC. 

Respondent notes, however, that deductions are a matter of

legislative grace and not a matter of right. Gladstone Co. v.
- 228 -

Commissioner, 35 B.T.A. 764, 768 (1937). Respondent contends

that section 882(c)(2) protects respondent from having to perform

the almost impossible task of properly apportioning and

allocating deductions for an uncooperative foreign taxpayer. 

In the instant cases, at this time, there exist two paths

for deciding whether LTD is entitled to a correlative adjustment,

but pursuant to either one, the result is the same: LTD is not

entitled to a correlative adjustment to its income. Following

the first path, if LTD does not file a U.S. income tax return by

the time the primary adjustment is made, LTD will fall out of the

section 482 regime entirely and will therefore be ineligible to

receive a correlative adjustment to its income. 

A correlative adjustment is made to the income of a taxpayer

only if such adjustment would have an effect on the U.S. income

tax liability of the taxpayer for any pending taxable year. Sec.

1.482-1(d)(2), Income Tax Regs. A "pending taxable year" is "any

taxable year with respect to which the United States income tax

return of the other member has been filed by the time the

allocation [the primary adjustment] is made, and with respect to

which a credit or refund is not barred by the operation of any

law or rule of law." Id. If LTD fails to file a U.S. income tax

return by the time the primary adjustment is made, LTD will have

no "pending taxable year" within the meaning of section 1.482-

1(d)(2), Income Tax Regs., and will therefore be ineligible for a

correlative adjustment to its income. 
- 229 -

Following the second path, if LTD files a U.S. income tax

return by the time the primary adjustment is made, LTD will be

precluded from taking its correlative adjustment, which would be

in the form of a section 882(c)(1)(A) deduction. The form of a

section 482 allocation, including the character and source of

amounts allocated, follows the substance of the particular

transaction that results in the avoidance of taxes or the failure

to reflect income clearly. Sec. 1.482-1(d)(1), Income Tax Regs. 

Appropriate adjustments may include, inter alia, an increase or

decrease in gross income, or an increase or decrease in

deductions. Id. 

In the instant case, the substance of the particular

transaction that results in the avoidance of taxes was an

underpayment by LTD to INC of fees for the performance of

personal services. The form of the section 482 allocations to

INC and LTD follows the substance of such transaction and

therefore consists of additional compensation for services for

INC and additional compensation expenses for LTD. Accordingly,

the character and source of the amounts allocated are: For INC,

personal services income from sources within the United States

includable in INC's gross income pursuant to section 61(a)(2),

and, for LTD, additional compensation expenses includable in

LTD's trade or business deductions pursuant to section

882(c)(1)(A). The form of the correlative adjustment to LTD’s

income is, therefore, an increase in the amount LTD is entitled
- 230 -

to deduct pursuant to section 882(c). Pursuant to Blenheim Co.

v. Commissioner, 125 F.2d 906 (4th Cir. 1942), and Georday

Enters., Ltd. v. Commissioner, 126 F.2d 384 (4th Cir. 1942),

discussed supra pp. 185-188, however, we hold that LTD is

precluded from receiving the benefits of any deductions it might

have otherwise been entitled to claim had it filed a timely,

true, and accurate return pursuant to section 882(c)(2). In the

instant case, the correlative adjustment to LTD’s income is in

the form of a deduction pursuant to section 882(c)(1)(A). 

Accordingly, LTD will not be entitled to a correlative adjustment

to its income. 

We have previously addressed the issue of double taxation

with regard to a section 482 correlative adjustment. In Collins

Electrical Co. v. Commissioner, 67 T.C. 911 (1977), we made a

primary adjustment against the taxpayer without addressing the

issue whether the related party, not a party to the action then

before us, would ultimately receive its correlative adjustment. 

We cautioned, however: 

We do not intend our holding on this issue to be read to

sanction a double tax on the same income--a tax as a result

of the primary adjustment without an accompanying

correlative adjustment. Section 482 indeed contemplates

that when the Commissioner allocates income to one commonly

controlled organization he will make a correlative

adjustment in the income of the other. * * * [Id. at 922-

923; fn. ref. omitted; citations omitted.] 

In Collins Electrical Co. and the cases cited therein, however,

we were not confronted with the additional factor of a foreign

corporation’s failure to file an income tax return. 
- 231 -

Where, as in the instant case, a foreign corporation fails

to file an income tax return, the interplay of section 882(c)(2)

and section 482 requires the denial of a correlative adjustment,

if such correlative adjustment is in the form of deductions the

taxpayer might have otherwise been entitled to claim had it filed

a timely, true, and accurate return. We note that allowing LTD

in the instant case to deduct its section 482 correlative

adjustment would produce an anomalous result with regard to LTD’s

section 882(c)(1)(A) deductions: The additional compensation

expenses allocated to LTD pursuant to section 482 would be

allowed but the compensation expenses already paid by LTD to INC

and the other business expenses (e.g., commissions to promoters,

etc.) would be disallowed pursuant to section 882(c)(2). As we

have discussed, supra pp. 185-188, LTD filed no return at all and

therefore failed to comply with the express requirement of

section 1.882-4(b)(1), Income Tax Regs. Consequently, we uphold

respondent’s disallowance of the deduction for LTD’s correlative

adjustment that LTD might have otherwise been entitled to claim

had it filed a timely, true, and accurate return pursuant to

section 882(c)(2). 

F. Remaining Issues

1. Positions of the Parties

Petitioners make no argument on brief concerning the

remaining issues set forth below in this paragraph F. 

Consequently, we consider such issues to have been conceded. 
- 232 -

35

Petitioners state that the branch profits tax is "to a large

extent, a computational issue which will depend on whether LTD

was engaged in a U.S. trade or business and to what extent, if

any, its income was effectively connected to such a business." 

Petitioners make no argument concerning the issue, and we

consider it to have been conceded. Rybak v. Commissioner, 91

T.C. 524, 566 (1988).

Rybak v. Commissioner, 91 T.C. at 566. Accordingly, we decide

the issues set forth below.

2. Issues With Respect to LTD

a. We hold that LTD is liable for the branch profits

tax imposed pursuant to section 884 for its taxable years ended

1988 and 1989;35

b. we hold that LTD is liable for the environmental

tax imposed pursuant to section 59A.

3. Issues With Respect to INC

a. We hold that INC is not entitled to deductions

claimed for legal and audit expenses for its taxable year ended

1986;

b. we hold that the net operating loss deduction

claimed by INC should not be increased for its taxable year ended

1985 and should not be decreased for the taxable year ended 1986;

c. we hold that the investment credit claimed by INC

should not be increased for its taxable year ended 1985 and

should not be decreased for its taxable year ended 1986.

4. Issues With Respect to Holdings

a. We hold that Holdings is not entitled to deductions

claimed for legal and audit fees for its taxable year ended 1987;
- 233 -

b. we hold that Holdings is not entitled to claimed

deductions for professional and legal fees for its taxable years

ended 1988 and 1989;

c. we hold that Holdings is not entitled to deductions

claimed for employee training and recruiting for its taxable year

ended 1989;

d. we hold that Holdings is liable for the

environmental tax pursuant to section 59A.

G. Additions to Tax

Respondent determined in notices of deficiency that

petitioners are liable for (1) the additions to tax imposed by

section 6651(a)(1) for failure to file timely income or

withholding tax returns, (2) the additions to tax imposed by

section 6653(a) for negligence or disregard of rules or

regulations, (3) the additions to tax imposed by section 6655(a)

for failure to pay estimated tax, (4) the additions to tax

imposed by section 6656(a) for failure to make timely deposits of

taxes, and (5) the additions to tax imposed by section 6661(a)

for substantial understatement of income tax. We shall examine

the additions to tax separately.

1. Section 6651(a)(1)

Section 6651(a)(1) imposes an addition to tax for failure to

file timely a tax return unless it is shown that such failure is

due to reasonable cause and not willful neglect. A taxpayer can

establish reasonable cause by showing that, despite the exercise

of ordinary business care and prudence, the taxpayer was unable
- 234 -

to file the required tax return within the prescribed time. 

United States v. Boyle, 469 U.S. 241, 246 (1985); Crocker v.

Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-1(c)(1),

Proced. & Admin. Regs. Alternatively, a taxpayer can establish

reasonable cause by showing reasonable reliance on an

accountant's or attorney's advice that filing a return was not

necessary, even when such advice turned out to have been

mistaken. United States v. Boyle, supra at 250. Willful neglect

has been defined as a conscious, intentional failure or reckless

indifference to timely filing a return. Id. The questions of

whether petitioners have acted with "reasonable cause" and not

"willful neglect" are questions of fact, and petitioners have the

burden of proof. Rule 142(a); Lee v. Commissioner, 227 F.2d 181,

184 (5th Cir. 1955), affg. a Memorandum Opinion of this Court. 

It is undisputed that (1) LTD did not file corporate income

tax returns for taxable years ended June 30, 1987 through 1989,

(2) LTD did not file withholding tax returns for calendar years

1984 through 1989, and (3) INC did not file withholding tax

returns for calendar years 1987 through 1989. We have held that

LTD is liable for corporate income tax for taxable years ended

June 30, 1987 through 1989, that LTD is liable as a withholding

agent for withholding tax on the dividend it paid to its

shareholders in calendar years 1985 and 1986, and that INC is not

liable as a withholding agent for withholding tax. Consequently,

we must decide whether LTD's failure to file corporate income tax

returns for taxable years ended June 30, 1987 through 1989 and
- 235 -

LTD’s failure to file withholding tax returns for calendar years

1985 and 1986 were due to reasonable cause and not due to willful

neglect. 

Petitioners seek to establish reasonable cause by showing

their reliance on the opinion of their tax counsel. Petitioners

cite Haywood Lumber & Mining Co. v. Commissioner, 178 F.2d 769,

771 (2d Cir. 1950), modifying 12 T.C. 735 (1949) in which the

court stated that "When a corporate taxpayer selects a competent

tax expert, supplies him with all necessary information, and

requests him to prepare proper tax returns, we think the taxpayer

has done all that ordinary business care and prudence can

reasonably demand." Petitioners contend that LTD and INC

provided full disclosure of all relevant facts to their

accountants and tax lawyers, and the returns prepared by such

professionals in accordance with such facts constitute tax advice

upon which LTD and INC may, in good faith, reasonably rely and

not be subjected to additions to tax for failure to file a

return. 

We conclude that petitioners have not met their burden of

proof. Petitioners have presented no evidence of receiving

advice from either an accountant or an attorney that filing a

return was unnecessary. The record contains one letter, dated

December 18, 1984, in which Mr. Bricker writes "in response" to

Deloitte's questions as to whether LTD "is subject to United

States income tax." Mr. Bricker concludes that LTD "is not

subject to United States tax other than on any 'fixed or
- 236 -

36

The workpapers for the audit of the taxable year ended June

30, 1988, do not mention the tax obligations of LTD. 

determinable annual or periodical' United States source income

that it may receive." In his letter, Mr. Bricker does not

address the issue of whether LTD must file a U.S. income tax

return. 

Similarly, Deloitte's workpapers do not address the issue of

whether LTD must file a U.S. income tax return. In its

workpapers for taxable years ended June 30, 1984, 1985, 1986,

1987, and 1989,36 Deloitte refers to section 8 of petitioners'

permanent file to support its conclusion that petitioners have no

U.S. tax liability. That section of the permanent file contained

Mr. Bricker's letter to Deloitte dated December 18, 1984, and a

Deloitte internal memorandum dated August 28, 1985, from R.V.

Valdez to Floyde W. Burnside, Jr., and Glen I. Robinson. R.V.

Valdez writes that Deloitte's tax analysis of LTD in the 1984 and

1985 financial statements is "appropriate" based on a discussion

with Burnside and Robinson and Valdez's own analysis. Deloitte's

financial statements for petitioners conclude that LTD "is not

subject to U.S. federal or state taxes on income as it has no

offices in the United States, no U.S. source income, and no

income effectively connected with the conduct of a U.S. trade or

business." 

We are not persuaded that petitioners relied upon Deloitte

for advice as to whether to file a U.S. income tax return. Mr.
- 237 -

Bricker was secretary and tax counsel of LTD, and he provided

legal advice to petitioners. Deloitte itself sought Mr.

Bricker's opinion on the issue of whether LTD is subject to U.S.

income tax. Petitioners do not contend that, implicit in the

advice of their attorney concluding that LTD was not engaged in a

U.S. trade or business, there was the additional counsel that

filing an income tax return was unnecessary. Mr. Bricker's

letter to Deloitte, in fact, states that LTD is still subject to

tax on any "fixed or determinable annual or periodical" U.S.

source income that it may receive. Petitioners have not

persuaded us that they received advice to the effect that filing

an income tax return was unnecessary. Consequently, we hold that

petitioners have not established reasonable cause and are

therefore subject to the section 6651(a)(1) addition to tax

relating to LTD’s income tax liability for taxable years ended

June 30, 1987 through 1989, and LTD’s withholding tax liability

for calendar years 1985 and 1986. 

2. Sections 6653(a)(1) and 6653(a)(1)(A)

The Code imposes an addition to tax that is equal to 5

percent of the entire underpayment if any part of it was due to

negligence or disregard of rules or regulations. Sec. 6653(a)(1)

(for petitioners’ taxable year ended June 30, 1985), sec.

6653(a)(1)(A) (for petitioners’ taxable years ended June 30, 1986

through June 30, 1988), sec. 6653(a)(1) (for petitioners’ taxable

year ended June 30, 1989). If the addition to tax applies, the

Code imposes a further addition to tax in an amount that is equal
- 238 -

to 50 percent of the interest payable with respect to the portion

of the underpayment that is attributable to negligence or

disregard of rules or regulations. Sec. 6653(a)(2) (for

petitioners’ taxable year ended June 30, 1985), sec.

6653(a)(1)(B) (for petitioners’ taxable years ended June 30, 1986

through June 30, 1988), sec. 6653(a)(2) (for petitioners’ taxable

year ended June 30, 1989). 

Respondent's determination that petitioners were negligent

is presumed correct, and petitioners bear the burden of proving

that they were not negligent. Rule 142(a); Bixby v.

Commissioner, 58 T.C. 757, 791-92 (1972). Pursuant to section

6653(a), negligence is defined as a failure to exercise the due

care that a reasonable and ordinarily prudent person would

exercise under the circumstances. Antonides v. Commissioner, 91

T.C. 686, 699 (1988) (citing Marcello v. Commissioner, 380 F.2d

499, 506 (5th Cir. 1967), affg. in part and remanding in part 43

T.C. 168 (1964)), affd. 893 F.2d 656 (4th Cir. 1990); Neely v.

Commissioner, 85 T.C. 934, 947 (1985). A taxpayer's failure to

file a timely tax return is a prima facie case of negligence. 

Emmons v. Commissioner, 92 T.C. 342, 349 (1989), affd. 898 F.2d

50 (5th Cir. 1990). 

Reliance on a return preparer, however, may relieve a

taxpayer from the addition to tax for negligence where the

taxpayer's reliance is reasonable. Freytag v. Commissioner, 89

T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd.

501 U.S. 868 (1991). A taxpayer, however, is not relieved from
- 239 -

liability for the addition to tax for negligence merely by

shifting the responsibility to a tax professional. Enoch v.

Commissioner, 57 T.C. 781, 802-803 (1972). Reliance on an expert

is not an absolute defense but is a factor to be considered. 

Freytag v. Commissioner, supra at 888. A taxpayer's reliance

must be in good faith and demonstrably reasonable. Ewing v.

Commissioner, 91 T.C. 396, 423 (1988), affd. without published

opinion 940 F.2d 1534 (9th Cir. 1991); Freytag v. Commissioner,

supra at 888-889. In such a case, a taxpayer will be entitled to

rely upon an expert's advice, even if the advice should prove to

be erroneous. Jackson v. Commissioner, 86 T.C. 492, 539 (1986),

affd. on other issues 864 F.2d 1521 (10th Cir. 1989); Brown v.

Commissioner, 47 T.C. 399, 410 (1967), affd. 398 F.2d 832 (6th

Cir. 1968). 

The ultimate responsibility for a correct return lies with

the taxpayer, who must furnish the necessary information to the

agent who prepared the return. Enoch v. Commissioner, supra at

802. In other words, reliance upon expert advice will not

exculpate a taxpayer who supplies the return preparer with

incomplete or inaccurate information. Lester Lumber Co. v.

Commissioner, 14 T.C. 255, 263 (1950). 

Turning to the facts of the instant cases, we note that LTD

did not file any income tax returns or withholding tax returns

and that INC did not file any withholding tax returns. We have

held that LTD is liable for corporate income tax for taxable
- 240 -

years ended 1987 through 1989, that LTD is liable as a

withholding agent for withholding tax on the dividend it paid to

its shareholders in calendar years 1985 and 1986, and that INC is

not liable as a withholding agent for withholding tax. Pursuant

to Emmons v. Commissioner, supra, we hold that LTD’s failure to

file timely income tax returns for taxable years ended June 30,

1987 through 1989 and LTD’s failure to file withholding tax

returns for calendar years 1985 and 1986 are prima facie cases of

negligence. Petitioners have not come forward with sufficient

evidence; i.e., they have not "overcome" or "put in equilibrium"

such a prima facie case. Id. at 349, and the cases cited

therein. As to LTD, petitioners did not proffer evidence tending

to meet or to rebut respondent's prima facie cases of negligence. 

Consequently, we sustain respondent's determinations that LTD, as

to its corporate income tax returns for taxable years ended June

30, 1987 through 1989, and its withholding tax returns for

calendar years 1985 and 1986, was negligent. 

As to INC's income tax returns and Holdings' income tax

returns, petitioners contend that reliance upon experienced

advisers relieves them from the addition to tax for negligence. 

Petitioners, however, have not provided sufficient evidence to

prove that such reliance was reasonable. Ewing v. Commissioner,

supra; Freytag v. Commissioner, supra. Consequently, we sustain

respondent's determination of section 6653 additions to tax for

INC and Holdings. 
- 241 -

37

Sec. 8001(a) of the Omnibus Budget Reconciliation Act of

1986, Pub. L. 99-509, 100 Stat. 1951, sets the amount of such

addition to tax at 10 percent of the amount of the underpayment,

effective for amounts assessed after Oct. 21, 1986, the date of

the enactment of the amendment.

3. Section 6655(a)

Section 6655(a) imposes an addition to tax for failure to

pay estimated income tax. Petitioners bear the burden of

disproving respondent's determination of an addition to tax

pursuant to section 6655(a). Rule 142(a).

As petitioners paid no estimated tax and offered no evidence

to explain their failure to do so, we sustain respondent's

determination. Id.

4. Section 6656(a)

Section 6656(a) imposes an addition to tax for failure to

deposit timely a tax in a Government depositary. The addition to

tax is equal to 10 percent of the underpayment.37 The addition

to tax does not apply if the failure to deposit timely is due to

reasonable cause and not to willful neglect. Sec. 6656(a). 

As with the section 6651(a)(1) additions to tax, petitioners

seek to establish reasonable cause by showing their reliance on

the opinion of their tax adviser and accountants. We apply the

standard for "reasonable cause" in section 6651(a)(1) to section

6656(a). We have held that LTD is liable for corporate income

tax for taxable years ended June 30, 1987 through 1989, that LTD

is liable as a withholding agent for withholding tax on the
- 242 -

dividend it paid to its shareholders in calendar years 1985 and

1986, and that INC is not liable as a withholding agent for

withholding tax. Applying the same reasoning as we applied,

supra pp. 223-226, for section 6651(a)(1), we conclude that

petitioners have not met their burden of proof as to their income

tax liability for taxable years ended June 30, 1987 through 1989,

and as to their withholding tax liability for calendar years 1985

and 1986. Petitioners have presented no evidence of receiving

advice from either an accountant or an attorney that depositing

timely a tax in a Government depositary was unnecessary. Mr.

Bricker’s letter "in response" to Deloitte’s questions as to

whether LTD "is subject to United States income tax" does not

address the issue of whether LTD must deposit timely a tax in a

Government depositary. 

We are not persuaded that petitioners relied upon Deloitte

for advice as to whether to deposit timely a tax in a Government

depositary. Mr. Bricker was secretary and tax counsel of LTD,

and he provided legal advice to petitioners. Deloitte itself

sought Mr. Bricker’s opinion on the issue of whether LTD is

subject to U.S. income tax. Petitioners do not contend that,

implicit in the advice of their attorney concluding that LTD was

not engaged in a U.S. trade or business, there was the additional

counsel that depositing timely a tax in a Government depositary

was unnecessary. Mr. Bricker’s letter to Deloitte, in fact,

states that LTD is subject to tax on any "fixed or determinable
- 243 -

annual or periodical" U.S. source income that it may receive. 

Petitioners have presented no evidence of receiving advice that

depositing timely a tax in a Government depositary was

unnecessary. Consequently, we hold that petitioners have not

established reasonable cause and are therefore subject to the

section 6656(a) additions to tax relating to LTD’s income tax

liability for taxable years ended June 30, 1987 through 1989, and

LTD’s withholding tax liability for calendar years 1985 and 1986.

5. Section 6661(a)

Section 6661(a) imposes an addition to tax on a substantial

understatement of income tax. For corporations, an

understatement is substantial where it exceeds the greater of 10

percent of the tax required to be shown on the return or $10,000. 

Sec. 6661(b)(1)(A) and (B). The section 6661 addition to tax is

not applicable, however, if there was substantial authority for

the taxpayer's treatment of the items in issue or if relevant

facts relating to the tax treatment were disclosed on the return. 

Sec. 6661(b)(2)(B)(i) and (ii). Petitioners bear the burden of

disproving respondent's determination of an addition to tax

pursuant to section 6661. Rule 142(a). 

Petitioners have not presented any authority to support

their treatment of the items at issue other than the cases that

we have distinguished, supra pp. 85-92. There was no disclosure

of the relevant facts on a return. Consequently, we sustain

respondent's determination of an addition to tax pursuant to
- 244 -

section 6661. Antonides v. Commissioner, 91 T.C. at 700-704. 

All other arguments made by petitioners have been considered

and found to be without merit. 

To reflect the above, 

Decisions will be entered

under Rule 155.