Tax Court holds foreign partnership income is subpart F income: Brown decision reversed.

In a reviewed opinion, the Tax Court held income earned by a foreign partnership and received by an affiliated group member is subpart F income includible in the member's gross income under Sec. 951(a) as foreign base company sales income.

Background: Brown I

In 1985 and 1986, Brown Group Inc. (BG), a New York corporation, had divisions that sold footwear at the retail and wholesale levels, and manufactured and imported footwear. BG manufactured footwear in the U.S. and imported footwear from Brazil.

Ownership structure

BG owned 100% of the stock of Brown Group International (International), a domestic subsidiary that in turn owned 100% of the stock of Brown Cayman Ltd. (BCL), a Cayman Islands corporation. International was a U.S. shareholder of BCL within the meaning of Sec. 951(b), and BCL was a controlled foreign corporation (CFC) within the meaning of Sec. 957(a). BCL owned 88% of Brinco, a partnership that acted as a purchasing agent for BG for footwear manufactured in Brazil. The remaining 12% of Brinco was owned by Ted Presti (10%), a U.S. citizen, through a two-tier structure of corporations, i.e., T.P. Cayman Ltd. (TPCL) and TPCL's parent, and Delcio Birck (2%), a citizen of Brazil.

Presti and Birck worked for a company that bought Brazilian shoes on behalf of BG, and BG formed Brinco with Presti and Birck to smooth out the purchasing and importation process. BG paid Brinco a 10% commission for acting as its Brazilian purchasing agent.

From approximately April through November 1985, TPCL received guaranteed payments totaling $151,662, instead of its share of partnership profits called for in the Brinco partnership agreement. After making guaranteed payments to TPCL, Brinco's net partnership earnings totaled about $917,000, of which $897,000 was distributed to BCL and $20,000 distributed to Birck. In 1986, TPCL received its share of partnership profits as called for in the Brinco partnership agreement.

At the end of October 1987 Brinco was dissolved. Presti became executive vice president of International, while Birck, as an independent agent, continued to source footwear for BG on a commission basis.

The IRS determined that BCL's distributive share of Brinco's earnings was foreign base company sales income currently includible as subpart F income in International's gross income; BG challenged this determination. The Tax Court held in favor of BG in Brown Group, Inc., 102 TC 616 (1994), but the opinion was with-drawn and the case assigned to another division.

Brown II

In Brown Group, Inc., 104 TC No. 5 (1995), the Tax Court reversed its earlier decision and determined that income earned by the foreign partnership gave rise to foreign base company sales income, currently includible in International's gross income under Sec. 951(a). The court reasoned the result was compelled by

--a close reading of the regulations under subpart F,

--a consideration of the structure and language of subchapter K,

--Congress's purpose in enacting subpart F, and

--the language of Sec. 954(d)(1).

The question before the Tax Court was whether BCL had income "derived in connection with...[t]he purchase of personal property from any person on behalf of a related person" under Sec. 954(d)(1).

Regarding subpart F's conduit approach, the Tax Court stated that "the parallel with subchapter K is obvious." Subpart F was intended to remove the tax deferral benefits of certain offshore operations that Congress considered "tax haven" devices, plus the facts presented were "ripe for the application of subpart F [because a] contrary result would lead to just the type of siphoning of profits that Congress was concerned with when it subjected foreign base company sales income to the conduit treatment of subpart F." Emphasizing the aggregate nature of Brinco, the Tax Court concluded BCL should be put into Brinco's shoes in determining whether BCL was earning income on sales by third parties to International. Finally, the court wrote BCL was a CFC, and its distributive share of partnership profits was connected to and dependent on purchases made on behalf of a party related to BCL and therefore subpart F income.