107 T.C. No. 10
UNITED STATES TAX COURT
SDI NETHERLANDS B.V., f.k.a.
SDI INTERNATIONAL B.V., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23747-94. Filed October 2, 1996.
P was the licensee of a Bermuda corporation (SDI
Bermuda) of worldwide rights to use computer software.
P in turn licensed those rights for use in the United
States to a U.S. corporation (SDI USA). P received
royalties from SDI USA as well as from other licensees.
P paid specified percentages of the royalties it
received from its licensees to SDI Bermuda. P, SDI
USA, and SDI Bermuda were members of a group of
corporations under common control. Held, the two
licenses were separate and distinct from each other
with the result that the royalties paid to P by SDI USA
did not retain their U.S. source character as part of
the royalties paid by P to SDI Bermuda. Consequently,
they were not income "received from sources within the
United States by" SDI Bermuda within the meaning of
sec. 881 (a), I.R.C., so as to subject P to withholding
tax as provided in secs. 1441(a) and 1442(a), I.R.C.
Arthur D. Pasternak, Douglas R. Cox, and Jeffrey A. Fiarman,
for petitioner.
Karen E. Chandler and Kristine A. Roth, for respondent.
OPINION
TANNENWALD, Judge: Respondent determined deficiencies in
Federal withholding taxes and additions to tax as follows:
Additions to Tax
Year Deficiency Sec. 6651(a)(1)1
1987 $678,449 $169,612
1988 881,067 220,267
1989 825,513 206,378
1990 641,837 160,459
The issue in dispute is whether petitioner, a corporation
organized under the laws of the Kingdom of The Netherlands, is
liable for withholding taxes on royalties paid to a Bermuda
corporation, and additions to tax for failure to file Forms 1042
for each of the years in issue.
All the facts have been stipulated. The stipulation of
facts and attached exhibits are incorporated herein by this
reference.
1
All section references are to the Internal Revenue Code in
effect for the years in issue, and Rule references are to the Tax
Court Rules of Practice and Procedure.
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Background
Petitioner is a foreign corporation organized in 1974 under
the laws of the Kingdom of The Netherlands. Petitioner was
formerly known as SDI International B.V. and, prior to that, as
Software Design Dervis B.V.2 Petitioner is the successor in
business to Software Design Sebas B.V., a foreign corporation
organized in 1972 under the laws of the Kingdom of The
Netherlands.
At the time of filing the petition, petitioner maintained
its principal office in Rotterdam, The Netherlands.
During the years in issue, petitioner was a member of an
affiliated group of companies (the SDI Group) whose members
designed, manufactured, marketed, and serviced commercial systems
software for use on IBM mainframe computers worldwide.
SDI Ltd., a corporation organized under the laws of Bermuda,
is the parent company of the SDI Group. During the years in
issue, petitioner was a wholly owned subsidiary of SDI Antilles,
a Netherlands Antilles corporation, which was a wholly owned
subsidiary of SDI Ltd.
The SDI Group also included SDI Bermuda Ltd. (SDI Bermuda),
a corporation organized under the laws of Bermuda which, during
the years in issue was a wholly owned subsidiary of SDI Ltd.
2
Reference to petitioner and other corporations who are members
of the SDI Group herein includes predecessor corporations.
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SDI USA, Inc. (SDI USA), a corporation organized under the
laws of the State of California was, during the years at issue, a
wholly owned subsidiary of petitioner.
Petitioner also had subsidiary corporations in Germany,
France, and the United Kingdom.
A brochure used by the SDI Group for the years in issue
describes SDI Ltd. as the "Corporate Office" of the SDI Group,
and petitioner, SDI USA and other members of the SDI Group as
"Marketing" offices of the SDI Group.
SDI Ltd. provided management services to certain of its
direct and indirect subsidiaries for which such subsidiaries paid
it management fees.
Royalty Payments Made By Petitioner
During the years in issue, petitioner licensed from SDI
Bermuda, pursuant to a license agreement dated November 28, 1986
(Bermuda license agreement), the worldwide rights to certain
commercial systems software for use on IBM mainframe computers
(the software). The Bermuda license agreement granted petitioner
a nonexclusive license to use or to market the use of, on a
worldwide basis, all of the software and any and all industrial
and intellectual property rights SDI Ltd. had or would acquire
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from the effective date of the agreement3, in exchange for
certain royalty payments. The agreement further provided that
petitioner "shall specifically have the right to grant
sublicenses and Agents for the right to use and to market the use
of any and all marketing rights granted to [petitioner] under the
terms" of the agreement. The agreement was valid for an
indefinite period and could be unilaterally terminated by either
party on 3 months' written notice.
The Bermuda license agreement contained no express reference
to the United States.
With respect to royalties, the Bermuda license agreement
provided:
8.1 The royalties payable to [SDI Bermuda] by [petitioner]
under this Agreement are fixed at 93% of the net amount
of all of the royalties due to [petitioner] by all
persons, entities and institutions which [petitioner]
sublicensed any of the rights licensed to [petitioner]
under this Agreement ("Sublicensees"). The
aforementioned net amount is the amount that remains
after the deduction of the withholding tax on royalties
to be withheld when the Sublicensees of [petitioner] or
Agents of [petitioner] pay the royalties due to the
[petitioner].
8.2 The aforementioned percentage of 93% will be increased
if the net amount of royalties received by [petitioner]
exceeds * * * in a specific accounting period [the
following amounts in Dutch florins]:
3
The record does not explain how or from whom SDI Ltd., known
in l986 as Castle Investments Ltd., acquired its existing rights,
but it is clear that at least some of them had been previously
owned by petitioner's predecessor.
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If [Petitioner's] but not Then the Percentage
royalty receipts for that portion to
exceed: be paid on will be:
Dfl Dfl Percent
2.000.000,= 4.000.000,= 94
4.000.000,= 6.000.000,= 95
6.000.000,= 8.000.000,= 96
8.000.000,= 10.000.000,= 97
10.000.000,= 98
* * * * * * *
8.3 All royalties payable to [SDI Bermuda] under this
Agreement shall be due within 28 days from the moment that
the royalties to be paid by the Sublicensees shall be due to
[petitioner]. All royalties payable to [SDI Bermuda] under
this Agreement, will be paid by [petitioner] at the option
of the [petitioner], in the same currency or in U.S. Dollars
in which the royalties due to [petitioner] are payable.
8.4 [Petitioner] shall annually provide [SDI Bermuda] with
a survey of all royalties due by the Sub-licensees and
pay [SDI Bermuda] in accordance with subsection 8.1
hereof. Any additional payments due to [SDI Bermuda]
pursuant to subsection 8.2 shall be made immediately
after the approval of the annual accounts of
[petitioner]. [SDI Bermuda] has the right to have a
representative examine [petitioner's] accounts.
Petitioner made royalty payments to SDI Bermuda, pursuant to
the Bermuda license agreement, during the years in issue, in the
following amounts:
1987 $3,583,983
1988 5,104,781
1989 5,146,862
1990 4,768,349
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The above payments constituted the following percentages of
the total worldwide royalty payments received by petitioner with
respect to the software:
Total Royalty
Year Percentage Payments Received
1987 93.89 $3,817,182
1988 95.94 5,320,816
1989 94.93 5,421,908
1990 95.60 4,987,662
Royalty Payments Received by Petitioner from SDI USA
During the years in issue, petitioner was a party to an
exclusive license agreement with SDI USA, dated October 1, 1972,
and as modified from time to time, regarding the use and
licensing of the software in the United States (the U.S. license
agreement).4 SDI USA was responsible for the direct marketing
and sales of the software in the United States.
The U.S. license agreement provided in part:
2.1 In consideration for the payment of the
royalties provided hereunder and the performance of the
other terms and conditions hereof by [SDI USA],
[petitioner] hereby grants and transfers to [SDI USA],
upon the terms and subject to the conditions
hereinafter set forth, the exclusive right and license
during the Term hereof, to have disclosed to it by
[petitioner] and to exploit, use and lease and
otherwise obtain the benefit of [the software] within
the Territory.
4
At the time this agreement was executed, petitioner was known
as Software Design Sebas B.V. (later known as Software Design
Dervis B.V.), and SDI USA was known as Software Design, Inc.
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2.2 This Exclusive License shall include, (i) the
right to sublicense to others the use and lease of [the
software] within the Territory, subject, however, to
the terms and conditions of this License; and (ii) this
License shall also include the right and, as
hereinafter provided, the obligation of [SDI USA], to
provide or to provide for the exclusive maintenance,
servicing and repair of [the software] within the
Territory. * * *
* * * * * * *
2.4 The Territory of this License shall mean and
be restricted to the continental United States, Hawaii
and Alaska.
Petitioner agreed not to license the software for use or to
compete directly or indirectly with SDI USA's exploitation of the
software in the United States during the term of its license to
SDI USA.5
Until February 1987, the agreement provided that SDI USA
would pay to petitioner "an annual royalty equal to fifty percent
(50%) of the annual gross revenues of [SDI USA] from leasing and
sublicensing of [the software], without any deductions therefrom
except rebates, discounts and sales or value added taxes."
The U.S. license agreement was modified in February 1987 to
provide that SDI USA would pay petitioner "a royalty equal to
(50%) fifty percent of the gross billable or invoiced revenues of
[SDI USA] with regard to all products licensed herein or further
5
In l986, these rights became exclusive only as between
petitioner and SDI USA and were otherwise subject to the
nonexclusive worldwide rights that petitioner acquired at that
time.
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licensed in the future, without any deductions therefrom except
rebates, or, sales or value added taxes."
Petitioner received royalty payments pursuant to the U.S.
license agreement from SDI USA, during the years in issue, in the
following amounts:
1987 $2,663,401
1988 2,936,889
1989 3,092,710
1990 2,139,458
Respondent mailed notices of deficiency to petitioner, one
for 1987, 1988, and 1989, and one for 1990, on July 29, 1994.
The parties have stipulated the amounts of royalties
received by petitioner from SDI USA and paid by petitioner to SDI
Bermuda. As a consequence, it appears that these amounts, if
subject to withholding tax, would produce deficiencies greater
than those determined in the notices of deficiency for 1987,
1988, and 1990 and a lesser amount for 1989. Respondent has made
no specific request for any increased deficiencies.
Discussion
Increased Deficiencies
Section 6214(a) provides that this Court has jurisdiction to
determine an increased deficiency "if claim therefor is asserted
* * * at or before the hearing or a rehearing". Under the
circumstances herein, where the amounts upon which the
mathematical calculation of the withholding tax is based have
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been stipulated by the parties and where the issue upon which the
liability for both the original and the increased deficiencies
depends is the same, we think that respondent has made a timely
claim for the increased deficiencies and see no reason to
preclude our consideration of such increases. See Pallottini v.
Commissioner, 90 T.C. 498, 500 (1988); cf. Law v. Commissioner,
84 T.C. 985, 989 (1984).6 Indeed, as we understand petitioner's
position, it does not oppose such consideration except in the
context of its contention that the burden of proof should in any
event be shifted to respondent under Rule 142(a).
Burden of Proof
Petitioner argues that the notices of deficiency refer only
to section 1441, so that reliance by respondent on section 1442
constitutes a new matter on which respondent has the burden of
proof under Rule 142(a). That burden of proof would, according
to petitioner, require respondent to prove that, during the years
in issue, SDI Bermuda was not engaged in a trade or business
within the United States or, if so engaged, that the royalties
received from petitioner by SDI Bermuda were not effectively
connected with such trade or business7; if SDI Bermuda were so
6
See also Brown v. Commissioner, T.C. Memo. 1996-325; cf.
Wicker v. Commissioner, T.C. Memo. 1993-431, affd. without
published opinion 50 F.3d 12 (8th Cir. 1995).
7
Petitioner makes a further reference to placing the burden of
(continued...)
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engaged and the royalties so connected, no withholding would be
necessary.8 See secs. 1441(c), 1442(a) and (b), 881(a); secs.
1.1442-2, 1.1441-4, Income Tax Regs.
Initially, we deal with petitioner's position in respect of
the burden of proof without regard to the increases in
deficiencies for 1987, 1988, and 1990. In this connection, we
note that the fact that the case has been fully stipulated does
not alter the application of the burden of proof rules. Rule
122(b); Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. on
other grounds 943 F.2d 22 (8th Cir. 1991).
In Zarin v. Commissioner, 92 T.C. 1084, 1088-1089 (1989),
revd. on other grounds 916 F.2d 110 (3d Cir. 1990), we set forth
the following frame of reference for determining what is new
matter within the meaning of Rule 142(a):
Rule 142(a) provides that the burden of proof is
on petitioner, "except that, in respect of any new
matter, increases in deficiency, and affirmative
defenses, pleaded in his answer, it shall be upon the
respondent." A new position taken by respondent is not
necessarily a "new matter" if it merely clarifies or
7
(...continued)
proof on respondent in respect of the absence of income from
insurance includable under sec. 842, a reference which, under the
circumstances herein, we think is irrelevant.
8
We also note that, for purposes of this proceeding, respondent
does not contend that petitioner maintained an office or place of
business in the United States, engaged in trade or business
within the United States, or received income effectively
connected with the conduct of a trade or business within the
United States.
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develops respondent's original determination without
requiring the presentation of different evidence, being
inconsistent with respondent's original determination,
or increasing the amount of the deficiency. Achiro v.
Commissioner, 77 T.C. 881, 889-891 (1981).
The notices of deficiency herein provide in pertinent part:
The payments you made to nonresident aliens in the
amounts shown are subject to the withholding rate
provided by section 1441(a) of the Internal Revenue
Code. Since you did not withhold the tax, and did not
establish that the recipient of the payments paid the
United States tax, you are liable for the tax that
should have been withheld. * * *
We think that section 1441, which imposes the withholding
tax on nonresident alien individuals and foreign partnerships,
was cited only for the rate of tax applied by respondent.
Respondent cited no section for the source of the deficiencies,
nor, indeed, was respondent required to do so. Jarvis v.
Commissioner, 78 T.C. 646, 655-656 (1982). The language of the
notices did not, directly or by necessary inference, exclude a
claim under section 1442, which imposes the withholding tax on
foreign corporations and upon which respondent proceeds herein.
Moreover, section 1442 makes reference to and incorporates
section 1441 so that reference to section 1441 is entirely
appropriate in a proceeding under section 1442. See Central de
Gas de Chihuahua, S.A. v. Commissioner, 102 T.C. 515, 517 (1994).
Beyond this, the very elements of section 1442 upon which
petitioner relies to shift to respondent the burden of proof,
i.e., the burden of proving that SDI Bermuda was not engaged in
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trade or business within the United States or, if so engaged,
that the royalties were not effectively connected with such trade
or business, are also present in the application of section 1441.
See also secs. 1.1442-2 and 1.1441-4, Income Tax Regs. Compare
sec. 1442(b)9 with sec. 1441(c)10. Thus, there is no
inconsistency in applying section 1442 rather than section 1441
herein since similar evidence is involved in providing a basis
for determining whether or not a taxpayer is exempt from
withholding under either section. Inconsistency and the absence
of a need for different evidence are critical elements in
9
Sec. 1442(b) provides:
(b) Exemption.--Subject to such terms and
conditions as may be provided by regulations prescribed
by the Secretary, subsection (a) shall not apply in the
case of a foreign corporation engaged in trade or
business within the United States if the Secretary
determines that the requirements of subsection (a)
impose an undue administrative burden and that the
collection of the tax imposed by section 881 on such
corporation will not be jeopardized by the exemption.
10
Sec. 1441(c) provides:
(c) Exceptions.--
(1) Income connected with United States
business.--No deduction or withholding under
subsection (a) shall be required in the case of
any item of income (other than compensation for
personal services) which is effectively connected
with the conduct of a trade or business within the
United States and which is included in the gross
income of the recipient under section 871(b)(2)
for the taxable year.
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deciding whether a "new matter" is involved that requires that
the burden of proof be shifted to respondent. See Zarin v.
Commissioner, supra; Estate of Emerson v. Commissioner, 67 T.C.
612, 620 (1977).
Finally, we note that petitioner itself contributed to any
confusion that may have existed in respect of the applicability
of section 1442 or section 1441, referred to in the notices of
deficiency. Prior to the time the notices of deficiency were
prepared, respondent had received limited information regarding
the royalty payments at issue. In particular, it was unclear to
whom, and in what amount, the royalty payments were being made.
Only just prior to the date set for trial and after prodding by
the Court did petitioner come forth with evidence as to whom and
in what amounts the royalties were paid.
In sum, since the essential elements of proof are the same
under the circumstances herein whether section 1441 or section
1442 provides the key to decision, there is no surprise or
unfairness in rejecting petitioner's contention that the burden
of proof should be shifted to respondent. See Stewart v.
Commissioner, 714 F.2d 977, 990-991 (9th Cir. 1983), affg. T.C.
Memo. 1982-209.11
Liability for Withholding
11
See also Ruark v. Commissioner, T.C. Memo. 1969-48, affd. per
curiam 449 F.2d 311 (9th Cir. 1971).
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Section 881(a) provides that a 30-percent tax shall be
imposed on "the amount received from sources within the United
States by a foreign corporation" falling within certain
categories of income.12 Section 1442 provides a method for
collecting that tax. Central de Gas de Chihuahua, S.A. v.
Commissioner, 102 T.C. at 519.
Section 1442 provides in part:
(a) General Rule.-- In the case of foreign
corporations subject to taxation under this subtitle,
there shall be deducted and withheld at the source in
the same manner and on the same items of income as is
provided in section 1441 a tax equal to 30 percent
thereof. * * *
Royalties are among the types of income included in section
1441(b). Sec. 1.1441-2(a), Income Tax Regs.; see also sec.
1.881-2(b), Income Tax Regs. In addition, section 861(a)(4)
provides that U.S. source income includes:
(4) Rentals and Royalties.--Rentals or royalties
from property located in the United States or from any
interest in such property, including rentals or
royalties for the use of or for the privilege of using
in the United States patents, copyrights, secret
processes and formulas, good will, trade-marks, trade
brands, franchises, and other like property.
Section 1441(a) completes the picture of the statutory
provisions involved herein. It provides:
12
A "foreign" corporation is a corporation that is not created
or organized in the United States or under the law of the United
States or of any State. Sec. 7701(a)(4) and (5).
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all persons * * * having the control, receipt, custody,
disposal, or payment of any of the items of income
specified in subsection (b) [which includes
"royalties"] (to the extent that any of such items
constitutes gross income from sources within the United
States), of any nonresident alien individual or of any
foreign partnership shall * * * deduct and withhold
from such items a tax equal to 30 percent thereof * * *
There can be no dispute that the royalty payments received
by petitioner from SDI USA constitute U.S. source income and were
received by petitioner as such within the meaning of section
1442(a). See Commissioner v. Wodehouse, 337 U.S. 369 (1949); see
also Estate of Marton v. Commissioner, 47 B.T.A. 184 (1942).
However, royalties paid by SDI USA to petitioner are exempt from
taxation by virtue of section 894 and article IX of the United
States-Netherlands Income Tax Convention, April 29, 1948, 62
Stat. 1757, 1762, 1950-1 C.B. 92, as amended by the Supplementary
Protocol, June 15, 1955, 6 U.S.T. 3696, 1956-2 C.B. 1116, and as
further amended by the United States-Netherlands Supplementary
Income Tax Convention, Dec. 30, 1965, 17 U.S.T. 896, 1967-2 C.B.
472 (U.S.-Netherlands treaty); see also sec. 894. There is no
comparable U.S. treaty exemption that would apply to royalty
payments from petitioner to SDI Bermuda.
The parties have locked horns on several aspects of the
application of the statutory provisions in light of the impact of
the U.S.-Netherlands treaty exemption: (1) Whether the royalties
paid by petitioner to SDI Bermuda constitute income "received
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from sources within the United States by" SDI Bermuda and are
thus subject to withholding under section 1441(a); (2) whether
petitioner can be considered a "withholding agent"; (3) whether
there is a limitations period that has expired in respect of
respondent's right to assess a deficiency in withholding tax
against petitioner; and (4) whether petitioner is liable for
additions to tax under section 6651(a)(1) for failure to file
withholding tax returns.
For reasons hereinafter set forth, we resolve the first
issue in petitioner's favor with the result that it is
unnecessary for us to address the remaining issues.13 Before
proceeding with our analysis of the first issue, however, it is
important to note that respondent does not question the existence
of petitioner as a valid Netherlands corporation or the
application of the treaty exemption insofar as the payments by
SDI USA to petitioner are concerned. Similarly, respondent does
not attack the arrangements under which petitioner had a license
of the worldwide rights and SDI USA had a license of the U.S.
rights, although respondent does ask us to take into account the
13
Similarly we have no need to decide further whether any
elements of proof should be placed on respondent under Rule
142(a) with respect of the increases in the deficiencies for
1987, 1988, and 1990 or whether any such burden should be applied
on an overall or year by year basis. See Zarin v. Commissioner,
92 T.C. 1084, 1089 (1989), revd. on other grounds 916 F.2d 110
(3d Cir. 1990).
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close relationship of the various corporations involved. Compare
Gaw v. Commissioner, T.C. Memo. 1995-531, on appeal (D.C. Cir.,
May 20, l996).
Rather, respondent focuses her argument solely on the
proposition that, since the royalties paid by SDI USA to
petitioner were U.S. source income, they retained that character
as part of the royalties paid by petitioner to SDI Bermuda and,
as a matter of law, constitute income "received from sources
within the United States by" SDI Bermuda under section 881(a).14
Respondent contends that the fact that such royalties were
combined with non-U.S. source royalties received by petitioner to
determine the amount of royalties payable by petitioner to SDI
Bermuda does not preclude the tracing of the royalties received
by petitioner from SDI USA to U.S. sources. To implement such
tracing, respondent simply applies the percentage specified in
the worldwide license agreement between petitioner and SDI
Bermuda and utilized in computing the amount of the required
payment by petitioner to SDI Bermuda. To support her contention
that such an allocation is permissible, respondent cites
Wodehouse v. Commissioner, 15 T.C. 799 (1950); Rohmer v.
Commissioner, 14 T.C. 1467 (1950); Rohmer v. Commissioner, 5 T.C.
14
At no time has respondent contended that petitioner has
failed to carry its burden of proof in respect of the factual
foundations of this legal issue.
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183 (1945), affd. 153 F.2d 61 (2d Cir. 1946); Estate of Marton v.
Commissioner, 47 B.T.A. 184 (1942); Molnar v. Commissioner, 156
F.2d 924 (2d Cir. 1946), affg. a Memorandum Opinion of this
Court. In all of these cases, however, the payments, upon which
a withholding tax was imposed, were directly from a U.S. payor
and the U.S. withholding tax was imposed on that payor. None of
them address the situation involved herein, where there is a
second licensing step under which royalties are being paid and
upon which the U.S. withholding tax is sought to be imposed.
Thus, these cases provide no guidance in respect of whether the
U.S. source characterization of the royalties paid by SDI USA to
petitioner flows through to the royalties paid by petitioner to
SDI Bermuda.
Petitioner argues that the royalties paid by SDI USA to
petitioner and exempt from tax under the Netherlands treaty
became merged with the other royalties received by petitioner
from non-U.S. sources and consequently lost their character as
U.S. source income. Petitioner submits that, while the royalty
payments from SDI USA may be U.S. source income, its royalty
payments to SDI Bermuda were made on a separate and independent
basis. With respect to the payments to SDI Bermuda, petitioner
contends that they were made pursuant to a worldwide licensing
agreement between two foreign corporations, and as such do not
constitute income "received from sources within the United
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States" so that no withholding is required under section 1442(a).
Pertinent authority on the issue before us is sparse.
Indeed respondent relies solely on Rev. Rul. 80-362, 1980-2 C.B.
208, for her "flow-through" position. In Rev. Rul. 80-362, A, a
resident of a country other than the United States and The
Netherlands, licensed the rights to a U.S. patent to X, a
Netherlands corporation. X agreed to pay a fixed royalty each
year to A. X relicenses those rights to Y, a U.S. corporation,
for use in the United States. In ruling that X was liable for a
withholding tax under section 1441, the ruling states:
In the present factual situation, the royalties
from Y to X are exempt from United States tax under
Article IX(1) of the Convention. However, the royalties
from X to A are not exempt from taxation by the United
States because there is no income tax convention
between A's country of residence and the United States
providing for such an exemption. Since the royalties
from X to A are paid in consideration for the privilege
of using a patent in the United States, they are
treated as income from sources within the United States
under section 861(a)(4) of the Code and are subject to
United States income taxation under section
871(a)(1)(A). [Rev. Rul. 80-362, 1980-2 C.B. at 208-
209.]
We are not persuaded that Rev. Rul. 80-362, supra, provides
any significant support for respondent's position herein. It
fails to reflect any reasoning or supporting legal authority.
This circumstance is particularly relevant in applying the usual
rule that, in any event, revenue rulings are not entitled to any
special deference. See Northern Indiana Public Service Co. v.
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Commissioner, 105 T.C. 341, 350 (1995), on appeal (7th Cir.,
March 13 and 25, 1996); Halliburton Co. v. Commissioner, 100 T.C.
216, 232 (1993), affd. without published opinion 25 F.3d 1043
(5th Cir. 1994).
At this point, we note that respondent has not argued that
petitioner was a mere conduit or agent of SDI USA in paying
royalties to SDI Bermuda or that SDI Bermuda was the beneficial
owner of the royalties petitioner received from SDI USA so that
the U.S.-Netherlands treaty exemption should not apply. Compare
Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971), with
Northern Indiana Public Service Co. v. Commissioner, supra; cf.
Estate of Petschek v. Commissioner, 81 T.C. 260 (1983), affd. 738
F.2d 67 (2d Cir. 1984). Presumably such an argument would have
produced a situation where SDI USA rather than petitioner would
have been targeted by respondent as the taxpayer liable for the
withholding tax under section 1442(a).15 See Northern Indiana
Public Service Co. v. Commissioner, 105 T.C. at 347.
Although Aiken Industries, Inc. v. Commissioner, supra, and
Northern Indiana Public Service Co. v. Commissioner, supra,
15
Given the basis for our disposition of this case, we have no
need to deal with the question whether petitioner, even though
only a conduit, would meet the statutory requirements of a
withholding agent. See sec. 1.1441-7, Income Tax Regs., which
provides that a foreign corporation can be a withholding agent.
See also Fides v. Commissioner, 137 F.2d 731 (4th Cir. 1943),
affg. 47 B.T.A. 280 (1942); Gaw v. Commissioner, T.C. Memo. 1995-
531, on appeal (D.C. Cir., May 20, 1996).
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involved the conduit concept, we think they provide some guidance
for our disposition of the instant case. We take this view
because the flow-through characterization concept is, in a very
real sense, the conduit concept albeit in a somewhat different
garb, i.e., whether the U.S. source income is being received as
such, because of the status of the paying entity in one case, and
the status of the subject matter of the payment in the other.
In Aiken Industries, Inc. v. Commissioner, supra, back-to-
back loans, in the identical amounts of principal and rates of
interest, were made between a U.S. corporation and a related
corporation organized under the laws of the Republic of Honduras,
and between the Honduran corporation and its indirect parent.
Respondent argued that the Honduran corporation should be
disregarded for tax purposes, and that the parent corporation
should be deemed the true owner and recipient of the interest
payment from the U.S. corporation. We held the Honduran
corporation to be a mere conduit for the passage of interest
payments and imposed withholding tax liability on the U.S.
corporation.
In Northern Indiana Public Service Co. v. Commissioner,
supra, the taxpayer, a domestic corporation, organized a finance
subsidiary incorporated in Curacao under the Commercial Code of
the Netherlands Antilles, (to which the U.S.-Netherlands treaty
applied) for the purpose of issuing notes in the Eurobond market.
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The finance subsidiary borrowed $70 million at 17-1/4 percent
interest in that market and lent that amount to the taxpayer at
18-1/4 percent interest. Respondent argued that the finance
subsidiary should be ignored and that the taxpayer was liable for
withholding taxes under section 1441 on the interest payments to
the foreign Eurobond holders. Finding that the finance
subsidiary engaged in substantive business activity that resulted
in significant earnings, we held that the finance subsidiary was
not a mere conduit or agent.
We think the within situation falls more within the ambit of
Northern Indiana than Aiken Industries. In the latter case,
there was an identity both in terms and timing between the back
to back loans, as well as a close relationship between the
parties involved. In the former case, although there was a clear
connecting purpose between the borrowing and lending
transactions, i.e., to obtain the benefit of the exemption from
the withholding tax on interest under the U.S.-Netherlands
treaty; there were differences in terms, i.e., in the interest
rate (albeit not large); and a close relationship between all the
parties was not present since the borrowings by the finance
subsidiary were from unrelated parties.
In the instant case, there was a close relationship between
the parties. However, although respondent asks us, in passing,
to take that relationship into account, she does not pursue the
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matter to the point where she contends that it is a significant
factor. Given the fact that respondent recognizes the existence
of all of the parties as valid corporate entities and does not
attack the bona fides of the license agreements between SDI USA
and petitioner, on the one hand, or petitioner and SDI Bermuda,
on the other, we are not disposed to allow the close relationship
element to control our decision.
The facts of the matter are that the two license agreements
had separate and distinct terms and that petitioner had an
independent role as the licensee from SDI Bermuda and the
licensor of the other entities, including but not limited to SDI
USA. The schedules of royalty payments provided for a spread,
not unlike the spread involved in Northern Indiana, which
compensated petitioner for its efforts. Like the finance
subsidiary in Northern Indiana, petitioner engaged in licensing
activities from which it realized substantial earnings. In fact,
on a percentage basis, it earned between 5 and 6 percent,
compared to the 1 percent earned by that finance subsidiary in
Northern Indiana.16 Under the circumstances herein, we think
these arrangements should be accorded separate status with the
result that, although the royalties paid by petitioner to SDI
16
In dollar amounts, petitioner retained net royalties in the
amounts of $233,199 in 1987, $216,035 in 1988, $275,046 in 1989,
and $219,313 in 1990.
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Bermuda were derived from the royalties received by petitioner
from SDI USA, they were separate payments.
We find support for our conclusion herein in that
respondent's view of the law could cause a cascading royalty
problem, whereby multiple withholding taxes could be paid on the
same royalty payment as it is transferred up a chain of
licensors. See, e.g., 1 Isenbergh, International Taxation: U.S.
Taxation of Foreign Persons and Foreign Income, par. 7.8, pp.
7:20-7:21 (2d ed. 1996); 2 Kuntz and Peroni, U.S. International
Taxation C1-45 - C1-46 (1992); Dale, "Withholding Tax on Payments
to Foreign Persons," 36 Tax L. Rev. 49, 66-67 (1980). But for
the U.S.-Netherlands treaty, the royalty payments from SDI USA
could be subject to withholding tax twice under respondent's
reasoning herein.
Respondent argues that only one withholding tax is being
sought herein. However, this ignores the fact that, by treaty,
the U.S. agreed to forgo taxing royalties and to allow them to be
taxed by The Netherlands. Whether or not The Netherlands
actually taxed the royalties is irrelevant.
Respondent also infers that she would use her discretion not
to apply more than one level of withholding tax on multiple
transfers of income that originated as U.S. source income. We
think this places an improper exercise of discretion in
respondent's hands. To avoid the imposition of interest and
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additions to tax as determined by respondent herein, each payor
in the chain might well feel compelled to file returns and pay
withholding taxes. See Glicklich, "Final Regulations on Conduit
Financing Arrangements Empower the IRS", 84 J. Taxn. 5, 12
(1996). We are not disposed to conclude, in the absence of any
legislative expression on the subject, that Congress intended the
statutory provisions to permit "cascading" with the question of
relief left to the mercy of respondent.
We hold that the payments by petitioner with respect to
which respondent seeks to impose liability for the 30 percent
withholding tax herein were not "received from sources within the
United States by" SDI Bermuda under sections 881(a), 1441(a), and
1442(a).17
Decision will be entered
for petitioner.
17
We note that changes in the U.S.-Netherlands treaty,
applicable to years subsequent to the years before us, may
provide a different framework for disposing of this issue.
Convention for the Avoidance of Double Taxation, U.S.-Neth.,
Dec. 18, 1992, Tax Treaties (CCH) par. 6103.01, as amended by
Supplementary Protocol, Oct. 13, 1993, Tax Treaties (CCH) par.
6116.