Court Opinion

ID: 4472407
Source: CourtListenerOpinion
Date Created: 2020-01-13 23:24:59.736726+00
Date Added: 2024-06-11T13:39:41.670314
License: Public Domain

Ruwe, J., concurring: I agree with the majority’s conclusion that Brown Cayman’s distributive share of Brinco’s partnership income is subpart F income. However, I believe that there are technical problems with the majority’s reliance on subchapter K and the related aggregate versus entity analysis. These problems can be avoided by simply applying the literal terms of section 954. I will first address the problems and then the solution. The Problems 1. Section 702 Section 702 provides that each partner must account separately for certain specifically enumerated types of partnership income, losses, and deductions that are described in section 702(a)(1) through (7). If a partnership item is not described in section 702(a)(1) through (7), section 702(a)(8) provides that a partner is to account for his distributive share as “taxable income or loss” from the partnership “exclusive of items requiring separate computation under other paragraphs of this subsection.” Sec. 702(a)(8). Section 702(b) provides that the character of any item of income that is included in a partner’s distributive share under section 702(a)(1) through (7) “shall be determined as if such item were realized directly from the source from which realized by the partnership”. Section 702(b)’s character pass-through requirement does not apply to the items covered by section 702(a)(8). The majority uses section 702(b) to characterize Brown Cayman’s distributive share of income from Brinco as commissions earned on the purchase of footwear. To do this, Brinco’s commission income must be an item described in section 702(a)(1) through (7). Paragraphs (1) through (6) are clearly inapplicable. The majority focuses on paragraph (7) to impute the character of Brinco’s commission income to Brown Cayman. Paragraph (7) provides that a partner must separately account for “other items of income * * * to the extent provided by regulations”. The regulation upon which the majority relies is section 1.702-l(a)(8)(ii), Income Tax Regs. Section 1.702-l(a)(8)(ii), Income Tax Regs., provides that “Each partner must take into account separately his distributive share of any partnership item which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately.” (Emphasis added.) In order for section 1.702-l(a)(8)(ii), Income Tax Regs., to apply, the tax liability of the “partner” must be affected by whether the partnership item is separately taken into account. The problem with applying this regulation to the facts in the instant case is that Brown Cayman is the partner in question, but it has no tax liability. Even if we treat Brown Cayman as if it were a domestic corporation liable for U.S. tax, its tax liability is in no way affected by separately accounting for and characterizing the partnership income attributable to Brinco’s commissions. Brown Cayman’s hypothetical tax liability would still be based on the income it derived from its distributive share of partnership income. Sec. 61(a)(13). That distributive share of partnership income would include partnership income attributable to Brinco’s purchase of footwear. However, the separate characterization of Brown Cayman’s income from Brinco as commission income would have no affect on Brown Cayman’s actual or hypothetical tax liability.1 It follows that section 1.702-1(a)(8)(h), Income Tax Regs., does not apply, and therefore the result the majority arrives at is not supported by its technical analysis.2  2. Aggregate vs. Entity While there may be areas in the law of partnership taxation where the aggregate versus entity issue still exists, I do not believe there is any remaining issue with respect to the type of specific partnership income items that must be characterized by individual partners as if they had realized the income directly from the source from which realized by the partnership. Congress has specifically provided statutory rules in section 702(a)(1) through (8) and subsection (b) that answer this question.3 In section 702(a)(7), Congress also gave the Department of the Treasury broad regulatory authority to specify additional partnership items that must be separately accounted for and characterized at the partner level. As previously explained, nothing in these partnership provisions requires that the character of the commission income that Brinco earned by purchasing footwear on behalf of Brown Group be separately stated and characterized at the partner level as if it had been “realized directly from the source from which realized by the partnership”. Sec. 702(b). Brown Cayman’s distributive share of partnership income falls under section 702(a)(8), and the separate character of the items making up such income does not pass through to the partners under section 702(b). The Solution 1. Section 954(d) Brown Group International (a U.S. corporation whose stock is wholly owned by Brown Group), Brown Cayman (a Cayman Islands corporation whose stock is wholly owned by Brown Group International), and Brinco (a Cayman Islands partnership in which Brown Cayman held an 88-percent interest) were formed in 1985 to facilitate the purchase of Brazilian footwear on behalf of Brown Group. Brinco earned commission income by acting as purchasing agent for Brown Group International. The issue is whether Brown Cayman’s distributive share of Brinco’s income is “subpart F income”. This question can be answered by determining whether Brown Cayman’s distributive share of partnership income from Brinco is foreign base company sales income within the meaning of section 954(d)(1).4  Section 954(d)(1) provides: SEC. 954(d). Foreign Base Company Sales Income.— (1) In GENERAL. — For purposes of subsection (a)(2), the term “foreign base company sales income” means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with * * * the purchase of personal property from any person on behalf of a related person where— (A) the property which is purchased * * * is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) * * * in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country. [Emphasis added.] There is no question that Brown Cayman is a controlled foreign corporation or that Brown Group International is a related person within the meaning of section 954(d). There is also no question that the footwear was “manufactured” or “produced” in Brazil, which is “outside the country under the laws of which the controlled foreign corporation is created or organized” (Cayman Islands). Sec. 954(d)(1)(A). Finally, there is no question that the footwear was “purchased for use, consumption, or disposition outside such foreign country.” Sec. 954(d)(1)(B). Thus, our only task is to determine whether Brown Cayman’s distributive share of Brinco’s profits is income of Brown Cayman (the controlled foreign corporation) that was “derived in connection with * * * the purchase of personal property * * * on behalf of a related person” within the meaning of section 954(d)(1). Brown Cayman’s distributive share of Brinco’s profits is clearly within the broad term “income (whether in the form of profits, commissions, fees, or otherwise)”. Sec. 954(d)(1). Brown Cayman “derived” this income “from” Brinco as part of Brown Cayman’s distributive share of Brinco’s profits. Under section 61(a), gross income means all income “from whatever source derived, including (but not limited to) the following items: * * * (13) Distributive share of partnership gross income.” (Emphasis added.) The only remaining question is whether Brown Cayman’s income from Brinco was “derived in connection with * * * the purchase of personal property * * * on behalf of a related person” within the meaning of section 954(d)(1). Brown Group International, Brown Cayman, and Brinco were organized and operated to purchase footwear for Brown Group. This was done by having Brinco act as the purchasing agent for Brown Grouji International. The purchase of footwear from Brazilian sources (i.e., “from any person”) was accomplished by Brinco acting as an agent on behalf of Brown Group International (“a related person”; i.e., related to Brown Cayman). Brinco’s purchasing activity as an agent for Brown Group International was the reason why commissions were generated. Those commissions, in turn, produced partnership profits and resulted in Brown Cayman’s distributive share of those profits. Brown Cayman’s distributive share of profits from Brinco was thus “derived in connection with * * * the purchase of personal property * * * on behalf of a related person.” Having met the literal provisions of section 954(d)(1), it becomes unnecessary to attribute the commission-earning activities directly to Brown Cayman through the application of section 702 or the aggregate approach. 2. Interpretation of “in connection with” The foregoing analysis relies on a broad reading of the term “in connection with”. This phrase has previously been given a broad interpretation. Snow v. Commissioner, 416 U.S. 500, 502-503 (1974); Huntsman v. Commissioner, 905 F.2d 1182, 1184 (8th Cir. 1990); Fort Howard Corp. v. Commissioner, 103 T.C. 345, 351—352 (1994). In Fort Howard Corp., we said that “in connection with” “means associated with, or related” and that “Events or elements are ‘connected’ when they are logically related’” to each other. Id. at 351-352.5 That relationship exists here. Brown Cayman’s distributive share of partnership profits was, by design and in reality, associated with, logically related to, and dependent upon commissions paid to Brinco for acting as a purchasing agent on behalf of a party related to Brown Cayman. Congress intentionally used the phrase “in connection with” in lieu of more narrow terms such as “from” or “for”,6 and a broad interpretation of the phrase is consistent with the legislative objective of subpart F. Subpart F was “designed to end tax deferral on ‘tax haven’ operations by U.S. controlled corporations.” S. Rept. 87-1881 (1962), 1962-3 C.B. 707, 785. Brown Cayman was a U.S. controlled corporation. Its operations consisted of being a partner in Brinco. Had Brown Cayman itself acted as purchasing agent and earned commissions as purchasing agent for Brown Group International, it would be clear that the commissions would be subpart F income. If we were to accept petitioner’s position, Brown Group could circumvent subpart F and successfully defer a significant amount of U.S. tax simply by establishing- and interposing a partnership (Brinco), whose profits would be distributable to Brown Cayman. During 1985, Brown Group paid commissions to Brinco of $1,119,970. These commissions were added to Brown Group’s cost of goods sold. Brinco distributed $897,281 during 1985 to Brown Cayman, its 88-percent partner. As a result, Brown Group reduced its gross profit for U.S. tax purposes by $1,119,970, while at the same time recouping $897,281 of that amount through its controlled foreign corporation without being subject to U.S. tax on the $897,281. Surely, Congress intended subpart F and the broad language of section 954(d)(1) to apply to this type of situation when it defined foreign base company sales income to include income “derived in connection with * * * the purchase of personal property * * * on behalf of a related person”.  The majority implicitly seems to recognize this problem. Their apparent solution is to conclude that “we must look to International’s tax liability to determine whether Brinco must separately state items, such as commission income, that could constitute foreign base company sales income.” (Majority op. pp. 113-114.) But International was not a “partner”; rather it was a shareholder. No authority is cited for the proposition that sec. 1.702-l(a)(8)(ii), Income Tax Regs., requires that we look beyond the real or hypothetical tax liability of a partner to the tax liability of an entity that is merely a shareholder of the corporate partner. Indeed, to do so is contrary to sec. 1.702-l(a)(8)(ii), Income Tax Regs., which requires the separate statement of a partnership item only when the partner’s tax liability would be affected by having the partner account for the item separately. International is not a partner, and thus its tax liability is not relevant under the plain language of sec. 1.702-l(a)(8)(ii), Income Tax Regs.    The fact that we are dealing with a situation that Congress may have intended to tax under subpt. F is not a justification for disregarding the plain language of the partnership provisions. In a case bearing a striking factual similarity to the instant case, the Government attempted to recharacterize foreign partnerships as corporations so that they would be “related persons” for purposes of subpt. F. This would have caused the income of a controlled foreign corporation to be subpt. F income. See MCA Inc. v. United States, 685 F.2d 1099 (9th Cir. 1982). The Court of Appeals for the Ninth Circuit rejected the Government’s argument. In MCA Inc., the Government apparently eschewed any reliance on the arguments it is making in the instant case.    As the majority correctly notes, for purposes of subpt. F, the income of a controlled foreign corporation is to be computed as if it were a domestic corporation. A domestic corporation holding an interest in a partnership would have to compute its income from a partnership in accordance with subch. K, which includes sec. 702.    Subpt. F income is a statutory term applicable only to income of a controlled foreign corporation. Sec. 952. Foreign base company sales income, as defined in sec. 954(d)(1), is includable in subpt. F income. Secs. 952(a), 954(a)(2). A controlled foreign corporation is not subject to U.S. tax on its subpt. F income. Rather, the controlled foreign corporation’s subpt. F income is includable in the taxable income of the shareholder(s) of the controlled foreign corporation. Sec. 951.   At issue in Fort Howard Corp. v. Commissioner, 103 T.C. 345 (1994), was whether the taxpayer could take deductions for the costs of obtaining financing necessary to carry out a plan to redeem its own stock. Prior to the enactment of sec. 162(k), such financing costs could be amortized and deducted over the life of the loan. Sec. 162(k) generally provides that “no deduction otherwise allowable shall be allowed * * * for any amount paid or incurred by a corporation in connection with the redemption of its stock.” (Emphasis added.) In Fort Howard Corp., we held that the financing costs were connected and related to the redemption and a necessary step in the taxpayer’s redemption plan. As such, we found that they came within the broad language of sec. 162(k) that disallowed deductions “incurred in connection with” the redemption.    For example, sec. 61 provides that gross income means “income from whatever source derived, including”: “Compensation for services”; “Gross income derived from business;” “Gains derived from dealings in property;” “Income from life insurance and endowment contracts;” and “Income from discharge of indebtedness”. (Emphasis added.)