Brown Group decision reversed.

The Tax Court reversed its original decision in Brown Group, Inc. v. Commissioner, ruling that a controlled foreign corporation's (CFC) distributive share of income from a foreign partnership be treated as if it was directly earned by the CFC and, therefore, characterized as subpart F income.

Generally, foreign income earned by a foreign corporation is not subject to U.S. tax until it is repatriated as a dividend to U.S. shareholders. An exception under subpart F of the Internal Revenue Code says a U.S. shareholder must include the pro rata share of the CFC's subpart F income in gross income. Subpart F income includes passive income and certain income earned outside a CFC's country of origin. The specific type of subpart F income involved in Brown Group was foreign base company sales income, or income from the sale of property that was manufactured and sold or purchased for use outside the country in which the CFC was organized.

Brown Group owned 100% of Brown Cayman, a Cayman Islands corporation. Brown Cayman was a CFC and owned 88% of a Cayman Islands partnership known as Brinco. Brinco was formed as an agent to purchase Brazilian-made footwear for Brown Group member companies. These companies paid Brinco a 10% commission for purchases.

In its initial opinion, the court ruled that the entity theory should apply in characterizing Brinco's commission income. This theory respects the separate legal existence of a partnership and characterizes income at the partnership level. Because subpart F income is defined as income earned by a CFC, the court ruled that commission income earned by Brinco could not be considered foreign base company sales income. A logical conclusion of this ruling was that income earned through a foreign partnership could never be subpart F income.

The Internal Revenue Service asked the court to review its initial decision and warned taxpayers not to rely on the opinion. Upon review, the court reversed the decision, characterizing commission income earned by Brinco as if it was earned by Brown Cayman. The court treated Brown Cayman as the purchasing agent and determined that the income earned from related parties on purchases of Brazilian footwear for use outside the Cayman Islands was properly characterized as foreign base company sales income and includable in the gross income of Brown Group under subpart F.

Observation: Although there is an argument that the foreign base company sales income would have to be earned through the activities of the CFC, the broad scope of the original decision incited considerable criticism from commentators as well as the IRS. It appears the Tax Court reversed its original opinion because of this pressure. --Kenneth Kral, CPA, international tax partner, Jack Serota, Esq., international tax manager, and Jeffrey Weiss, CPA, international tax consultant, at Price Waterhouse, New York City.