Distributive share of foreign partnership income held not subpart F income.

The Tax Court has ruled in Brown Group, 102 TC No. 24 (1994), that the distributive share of a foreign partnership's income allocated to a controlled foreign corporation (CFC) is not subpart F income. Because the subpart F rules are silent as to whether the entity approach or the aggregate approach to partnership taxation applies, the court concluded the proper level for characterization of subpart F income was the partnership level. In addition, because the partnership was not a CFC, none of the partnership's income (income from the purchase of goods and sales to Brown Group) was subpart F income under Sec. 952(a). The court also held that Rev. Rul. 89-72 improperly applied the aggregate approach to the taxation of partnership income.

The Brown Group, U.S. parent of a group of corporations, manufactured, imported and sold (through its divisions) footwear at retail and wholesale levels. The footwear was manufactured in the United States or imported from other countries, including Brazil. Brown Group International, a Delaware corporation and wholly owned Brown Group subsidiary incorporated in 1985, was a U.S. shareholder under Sec. 951(b) of Brown Cayman, Ltd., a CFC under Sec. 957(a).

In March 1985, Brown Cayman formed Brinco, a Cayman Islands partnership, with T.P. Cayman, which owned 10% and Delcio Rirck, which owned 2%. Brinco acted as the Brown Group's purchasing agent for footwear manufactured in Brazil and sold in the United States, receiving a 10% commission for its services. Brinco and Brown Cayman, Ltd. were not related parties under Sec. 954(d)(3) as in effect for the applicable year.

The IRS treated Brown Cayman's distributive share of Brinco's earnings as foreign base company sales income to Brown Cayman, and thus includible as subpart F income in Brown Group International's gross income. The Service argued that under the aggregate theory of partnership taxation, Brown Cayman's share of partnership commission income was derived from sales transactions executed on behalf of the Brown Group. Such income, if earned directly by Brown Cayman, would constitute foreign base company sales income. The Brown Group argued that because Brinco and Brown Cayman were not related parties, Brinco's income was not subpart F income to Brown Cayman.

The Tax Court reached the same conclusion as the taxpayer, but using a different rationale. The Tax Court reasoned that the commission income should be characterized at the partnership (and not at the partner) level. Since Brinco was not a CFC, Brinco's income would be subpart F income to Brown Cayman only if Brinco's existence as an entity was ignored and Brown Cayman was treated as if it engaged in Brinco's activities. The Tax Court felt that Brinco's existence as an entity should be respected, and the determination of whether Brown Cayman's distributive share of Brinco's income was subpart F income to Brown Cayman should be made at the partnership level. Since Brinco was not a CFC, its income was not subpart F income to Brown Cayman.

The Tax Court stated that the IRS's position in Rev. Rul. 89-72, adopting an aggregate theory of partnership taxation in characterizing the income of a partnership at the partner CFC level for determining subpart F income, was incorrect. The relevant provisions of subpart F are silent as to whether the entity or the aggregate approach applies in this context. Thus, the Tax Court looked outside the Code for interpretation, mostly to other case law. It stated that in nearly every context in which the issue of characterization was relevant, courts have concluded that the proper level for characterization of an item of income is at the partnership level (citing the characterization of the sale of property, the special allocation to a partner-taxpayer of royalties paid to the partnership, the attribution of a loss to a business, etc.).

The Service attempted to rely on the fact that other subpart F regulations (Regs. Secs. 1.954-6(g), 1.955A-2(d) and (g)(4)) apply the aggregate approach when interpreting Sec. 954(f). The court rejected this argument; those regulations explicitly adopt the aggregate approach based on Sec. 954(f)(2), which brings in a partnership's distributive share of shipping income. Since those regulations explicitly adopt the aggregate approach, the court concluded the entity approach was the general rule and should be followed absent specific guidance to the contrary.

Related-party issue

The Tax Court's rationale did not rely on Brinco's not being a related party to Brown Group. The court stated that subpart F income must be earned by a CFC; because Brinco was clearly not a CFC, none of the income earned by Brinco was subpart F income. This statement, coupled with the clear statement in the opinion that the character of income is determined at the partnership level, implied there would be no subpart F income even if Brinco and Brown Cayman were related parties.

This distinction is particularly important after 1986. The Tax Reform Act of 1986 changed the statutory definition of related parties for 1987 and later tax years; under current Sec. 954(d)(3), Brinco and Brown Cayman would be related parties. Thus, to obtain the same result in future years, Brown must stand for the proposition that a partnership does not produce base company sales income even if indirectly owned by the same entity. Such an interpretation allows a related partnership to avoid subpart F income when it purchases goods from a related person and resells to unrelated parties. Thus, companies could avoid foreign base company sales income by establishing a related-party partnership owned by wholly owned foreign subsidiaries that earns income from (or with respect to) related-party sales transactions. Brown is believed to provide substantial authority for this position.

Application to other types of subpart F income

Brown may be applied to other, similar types of subpart F income, such as foreign base company services income, foreign base company oil-related income and insurance income; these types of income require specific characterization at the CFC level to qualify as subpart F income. It is difficult to apply the Brown rationale to foreign personal holding company (PHC) income; once the income is characterized at the partnership level as interest, dividends, rents, royalties, etc., it constitutes foreign PHC income without further characterization at the partner level. Finally, it is unlikely Brown can be applied to avoid foreign base company shipping income, since Regs. Sec. 1.954-6(g) specifically states that shipping income earned by a partnership is treated as if earned directly by its partners. (The court cited this regulation as an example of the limited circumstances in which the limited circumstances in which the regulations explicitly require that subpart F income be determined at the partner level.)

Treasury's reaction

The Treasury has warned that taxpayers should not rely on Brown, since all steps will be taken to reverse this decision. The Tax Court has agreed to reconsider this case. Changes to regulations to apply the aggregate approach for all types of subpart F income or new legislation are other possible courses of action.