International Multifoods Corporation and Affiliated Companies v. Commissioner

108 T.C. No. 26

UNITED STATES TAX COURT

INTERNATIONAL MULTIFOODS CORPORATION AND AFFILIATED COMPANIES,
Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11643-92. Filed June 18, 1997.

On Mar. 30, 1987, P, a domestic corporation,
entered into an agreement with Borden to sell P's stock
in Paty, a limitada organized under the laws of the
Federal Republic of Brazil. P realized a loss upon the
sale of the Paty stock, which P reported as a U.S.
source loss for purposes of its foreign tax credit
computation under sec. 904(a), I.R.C. R determined
that the loss was foreign source.

Held: P's loss is sourced in the United States.
Sec. 865, I.R.C., which provides that income from the
sale of noninventory personal property is generally
sourced at the residence of the seller, is also
generally applicable in sourcing losses realized on the
sale of such property.
 - 2 -

David R. Brennan, John K. Steffen, Susan B. Grupe, and

Nathan P. Zietlow, for petitioner.

Jack Forsberg, for respondent.

RUWE, Judge: On March 26, 1992, respondent determined

deficiencies in petitioner's Federal income taxes as follows:

Taxable Year Ended Deficiency

Feb. 28, 1987 $2,962,380
Feb. 29, 1988 3,592,402

Petitioner paid these deficiencies following receipt of its

notice of deficiency and on June 1, 1992, filed a petition with

this Court claiming an overpayment of income tax for each year.

In International Multifoods Corp. v. Commissioner, 108 T.C.

25 (1997), we disposed of several issues in this case. In an

order accompanying the release of our opinion, we granted

respondent's motion to sever and hold the sole remaining issue in

abeyance. This remaining issue requires us to decide whether the

loss realized by petitioner on its sale of the stock of Paty

S.A.-Produtos Alimenticios, Ltda.,1 on March 31, 1987, is to be

sourced in the United States for purposes of computing

1
Hereinafter, we shall refer to Paty S.A.-Produtos
Alimenticios, Ltda., as Paty and to the issue in question as the
Paty stock loss issue.
 - 3 -

petitioner's foreign tax credit limitation under section 904(a).2

We severed this issue because the Department of the Treasury

(Treasury) issued proposed regulations on July 8, 1996, involving

the allocation of losses realized on the disposition of stock

(the stock loss regulations). The summary to the proposed

regulations stated that "The regulations are necessary to modify

existing guidance with respect to stock losses." 61 Fed. Reg.

35696 (July 8, 1996). Pursuant to the proposed regulations,

losses realized on the disposition of stock of a corporation in

which the taxpayer owns a 10-percent or greater interest

generally would be sourced in the residence of the seller. Sec.

1.865-2(a)(1), Proposed Income Tax Regs., 61 Fed. Reg. 35698

(July 8, 1996). With respect to losses realized on the

disposition of all other personal property, the proposed

regulations provide that section 1.861-8, Income Tax Regs., or

other administrative pronouncements will continue to apply. Sec.

1.865-1, Proposed Income Tax Regs., 61 Fed. Reg. 35698 (July 8,

1996). If the proposed regulations are finalized in their

current form, petitioner would be permitted to elect

retroactively to source its Paty stock loss in the United States.

See sec. 1.865-2(a)(1), (e)(2)(i), Proposed Income Tax Regs., 61

Fed. Reg. 35698-35700 (July 8, 1996).

2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable year in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
 - 4 -

In his motion to sever issue, filed on July 19, 1996,

respondent stated: "At this time, respondent is hopeful that the

proposed regulations will be finalized during the beginning of

the 1997 calendar year." On March 3, 1997, respondent filed a

status report, which indicated that the stock loss regulations

had not yet been finalized. On March 5, 1997, we ordered

respondent to file, on or before May 12, 1997, an additional

status report with respect to the finalization of these

regulations.

On March 13, 1997, petitioner filed a Motion for Court to

Decide Paty Loss Issue. In its motion, petitioner stated that on

the basis of respondent's March 3, 1997, status report, "it does

not appear that there is any specific date by which the proposed

regulations are targeted to be issued as a Treasury Decision."

Petitioner also argued that despite respondent's acknowledgment

that the adoption of the proposed regulations in their current

form would decide the Paty stock loss issue in petitioner's

favor, "Respondent continues to decline confessing error. The

only purpose for not doing so is to preserve the ability to

contest the Petitioner's treatment of the loss." Petitioner

maintained that "The prejudice is compounded by the fact that the

Petitioner has not only paid the full amount of the determined

deficiencies and interest thereon in the present case, it has

overpaid the deficiencies and interest based upon the settlement

of other issues." On April 29, 1997, respondent filed a Notice
 - 5 -

of Objection to Petitioner's Motion for Court to Decide Paty Loss

Issue, in which respondent contended that "It is in the interest

of judicial economy for the Court to continue to hold the PATY

stock loss issue in abeyance pending a further status report by

the respondent regarding the finalization of the stock loss

regulations." In a status report filed May 12, 1997, respondent

informed the Court that the proposed regulations were still not

finalized.

We agree with petitioner that the time has come to decide

this issue. In granting respondent's motion to sever, we relied,

in large part, upon respondent's statement that he was "hopeful"

that the proposed regulations would be finalized by the beginning

of 1997. It is now over 10 years since the enactment of section

865(j)(1) directing the Secretary to promulgate regulations

regarding this issue. However, as of the date of issuance of

this opinion, the regulations still remain in proposed form.

Petitioner has already paid the deficiencies determined in the

notice of deficiency and is entitled to a decision on the merits.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. At

the time its petition was filed, petitioner maintained its

principal place of business in Minneapolis, Minnesota. Damca

International Corp. (Damca) was a wholly owned subsidiary of

petitioner and joined in the filing of petitioner's consolidated
 - 6 -

Federal income tax return for the taxable year ended February 29,

1988.

Petitioner and Damca owned 100 percent of the outstanding

stock of Multifoods Alimentos, Ltda. (MAL). On February 22,

1979, MAL acquired 85 percent of the outstanding stock of Paty.

MAL and Paty were Brazilian "limitadas" organized under the laws

of the Federal Republic of Brazil.

Paty was a regional pasta manufacturer, which marketed its

products in the greater Rio de Janeiro area. Petitioner acquired

an indirect interest in Paty, because it believed Paty would be a

profitable investment. Through that investment, petitioner

sought to expand its presence in Latin America and provide its

stock with more appeal to the stockholding community.

By February 1982, petitioner and MAL had acquired the

remaining 15 percent of the stock outstanding in Paty. On

February 29, 1984, the Paty stock which MAL held was distributed

to petitioner and Damca upon MAL's liquidation. During its

fiscal year 1986, petitioner transferred all but one share of its

Paty stock to Damca.

Pursuant to a Quota Purchase Agreement,3 entered into on

March 30, 1987, petitioner and Damca sold their stock in Paty to

Borden, Inc., and its Panamanian subsidiary Borden S.A. Borden,

Inc., acquired one share of Paty stock, and Borden S.A., acquired

3
A share of stock in a Brazilian limitada is called a
"quota".
 - 7 -

the remaining 1,597,135,239 shares. The closing of the

transaction occurred at Borden, Inc.'s, offices in New York, New

York, on March 31, 1987.

Petitioner sold Paty because it proved to be an unprofitable

investment, principally due to price controls imposed by the

Brazilian Government. With the exception of the taxable year

ended February 29, 1980, Paty never generated net income for any

year subsequent to MAL's acquisition of an interest in Paty. At

the time of sale, Paty had a net deficit in earnings of

$5,053,076. Neither petitioner nor Damca received any dividends

from Paty.

Damca realized a loss of $3,922,310 upon the sale of its

Paty stock. Of that amount, petitioner reported only $3,772,310

as a loss due to a $150,000 error in calculating losses. On its

U.S. Corporation Income Tax Return (Form 1120) for the taxable

year ended February 29, 1988, petitioner reported the loss as a

U.S. source loss in computing its foreign tax credit limitation.

Respondent determined that the loss from the sale of the Paty

stock must be sourced outside the United States.

OPINION

The sole issue for decision is whether the loss realized by

petitioner on the sale of its Paty stock is to be sourced in the

United States for purposes of determining petitioner's foreign

tax credit limitation under section 904(a).
 - 8 -

Enacted as part of the Tax Reform Act of 1986, Pub. L. 99-

514, sec. 1211(a), 100 Stat. 2085, 2533, section 865 provides

that income from the sale of noninventory personal property

generally will be sourced at the residence of the seller.4 In

explaining the purpose behind the passage of section 865, the

House report stated:

Source rules for sales of personal property should
reflect the location of the economic activity
generating the income at issue or the place of
utilization of the assets generating that income. In
addition, source rules should operate clearly without
the necessity for burdensome factual determinations,
limit erosion of the U.S. tax base and, in connection
with the foreign tax credit limitation, generally not
treat as foreign income any income that foreign
countries do not or should not tax.

Although the title passage rule operates clearly,
it is manipulable. It allows taxpayers to treat sales
income as foreign source income simply by passing title
to the property sold offshore even though the sales
activities may have taken place in the United States.
In such cases, the foreign tax credit limitation may be
artificially inflated. In addition, foreign countries
are unlikely to tax income on a title passage basis.
Thus, the title passage rule gives U.S. persons the
ability to create foreign source income that is not
subject to any foreign tax, and that may ultimately be
sheltered from U.S. tax with unrelated excess foreign
tax credits. In addition, it gives foreign persons the
ability to generate income that should be subject to
U.S. tax.

4
Sec. 1211(a) is generally effective for taxable years
beginning after Dec. 31, 1986. See Tax Reform Act of 1986, Pub.
L. 99-514, sec. 1211(c)(1), 100 Stat. 2085, 2536.
 - 9 -

Because the residence of the seller generally is
the location of much of the underlying activity that
generates income derived from sales of personal
property, the committee believes that sales income
generally should be sourced there. * * * [H. Rept.
99-426, at 360 (1985), 1986-3 C.B. (Vol. 2) 1, 360.5]

Section 865(j)(1) provides that "The Secretary shall prescribe

such regulations as may be necessary or appropriate to carry out

the purpose of this section, including regulations * * * relating

to the treatment of losses from sales of personal property".

There is no dispute that the Paty stock sold by petitioner

constitutes personal property under section 865(a).

5
Congress created several exceptions to the application of
the general rule in sec. 865(a). For instance, the general rule
of sec. 865(a) is inapplicable to the sourcing of gain realized
on the disposition of personal property if depreciation
deductions have been allowed with respect to the property for
U.S. tax purposes. Pursuant to a recapture rule, any realized
gain (up to the amount of depreciation taken on the property)
generally receives the same source characterization as the
depreciation deductions. Sec. 865(c)(1). With respect to the
sale of intangible property, sec. 865(d)(1)(A) provides that the
general rule of sec. 865(a) is applicable only if the gain is
recognized on a payment that is not "contingent on the
productivity, use, or disposition of the intangible". In
addition, gain realized on a domestic corporation's sale of stock
in a foreign corporation is sourced outside the United States if
(1) the two corporations would be members of the same affiliated
group but for the exclusion of foreign corporations from
affiliated groups; (2) the foreign corporation is actively
engaged in a trade or business in a particular foreign country;
(3) for the 3-year period ending with the taxable year of the
foreign corporation immediately preceding the year in which the
stock disposition occurs, at least 50 percent of its gross income
was derived from the active conduct of a trade or business in
such foreign country; and (4) title to the stock passes to the
purchaser within the foreign country in which the business is
located. Sec. 865(f), (i)(4). Respondent does not argue that
any of the exceptions to the general rule of sec. 865(a) are
applicable in the instant case.
 - 10 -

Petitioner contends that section 865 compels symmetrical

treatment for gains and losses. Since it is a U.S. resident,

petitioner argues that its loss from the sale of the Paty stock

must be sourced in the United States. See sec. 865(a)(1),

(g)(1)(A)(ii). Respondent, on the other hand, contends that

section 865 applies solely to the sourcing of income from the

sale of personal property. The rules governing the allocation of

losses, respondent maintains, remain those contained in

regulations promulgated under sections 861(b) and 862(b).

Respondent argues that the Tax Reform Act of 1986 did not modify

the preexisting regulatory rules respecting the allocation of

losses from the sale of personal property.

Section 861(a) provides rules for sourcing gross income

within the United States, and section 862(a) provides similar

rules for sourcing gross income from sources without the United

States. Section 863(a) authorizes the Secretary to prescribe

regulations specifying the methods of allocation for expenses,

losses, and deductions that are derived from domestic and foreign

sources. Section 1.861-8(b), Income Tax Regs., provides that

deductions are allocated to the class of gross income to which

they are definitely related. Section 1.861-8(e)(7), Income Tax

Regs., provides rules for the allocation of losses on the sale,

exchange, or other disposition of a capital asset or property

described in section 1231(b). Pursuant to its provisions, such

losses are considered definitely related and allocable to the
 - 11 -

class of gross income to which the property ordinarily gives rise

in the hands of the taxpayer.

Respondent argues that petitioner's investment in Paty would

ordinarily give rise to foreign source dividend income, and,

therefore, petitioner's loss on the disposition of its Paty stock

constitutes a foreign source loss. See Black & Decker Corp. v.

Commissioner, T.C. Memo. 1991-557, affd. 986 F.2d 60 (4th Cir.

1993). Respondent argues that the fact that petitioner never

actually received any dividends from Paty is irrelevant to the

determination of the class of gross income to which the Paty

stock loss is allocable, since this determination is based on an

objective consideration of the facts and circumstances. See id.

Respondent's reliance upon sections 861 and 862 to justify

application of section 1.861-8(e)(7), Income Tax Regs., is

misplaced, as these sections are inapplicable in the instant

case. The Tax Reform Act of 1986 amended these sections to

eliminate their applicability to the sale of noninventory

personal property. See Tax Reform Act of 1986, sec.

1211(b)(1)(B) and (C), 100 Stat. 2536. The impact of these

changes becomes evident when current section 861(a) is read in

the context of section 861(b), which provides: "From the items

of gross income specified in subsection (a) as being income from

sources within the United States there shall be deducted the

expenses, losses, and other deductions properly apportioned or

allocated thereto". Following its amendment in the Tax Reform
 - 12 -

Act of 1986, section 861(a) no longer "specifies" gross income

that is derived from the sale of noninventory personal property.

Section 862(a) and (b) provides a substantially identical

provision with respect to income received from sources outside

the United States and related losses. Consequently, the pre-1987

versions of sections 861 and 862 are no longer applicable to

determine the source of gain or loss from the sale of

noninventory personal property.

Respondent's reliance upon our decision in Black & Decker

Corp. v. Commissioner, supra, is similarly misplaced. In Black &

Decker Corp., we determined that the taxpayer's worthless stock

loss from its investment in a foreign subsidiary was to be

allocated against foreign source dividend income and, therefore,

constituted a foreign source loss for purposes of computing the

taxpayer's foreign tax credit limitation. In affirming our

decision, the Court of Appeals for the Fourth Circuit noted that

the relevant transaction was governed by the Internal Revenue

Code of 1954. See Black & Decker Corp. v. Commissioner, 986 F.2d

at 62 n.1. The Court of Appeals stated: "we will discuss and

cite to that act [the 1954 Act] although the Internal Revenue

Code of 1986 now supersedes it." Id.

Section 865, which is applicable to the Paty transaction,

provides that income realized from the sale of noninventory

personal property generally will be sourced at the residence of

the seller. Section 865(j)(1) provides that "The Secretary shall
 - 13 -

prescribe such regulations as may be necessary or appropriate to

carry out the purpose of this section, including regulations

* * * relating to the treatment of losses". Nevertheless,

respondent contends that nothing in section 865 requires the

Treasury to promulgate "any particular rule" with respect to the

allocation of losses on the disposition of personal property. We

disagree. Through the enactment of section 865(j)(1) directing

the Secretary to promulgate regulations necessary to carry out

the purpose of this section (i.e., residence-based sourcing),

Congress intended to change the rules regarding the allocation of

losses realized on the sale of noninventory personal property.

Otherwise, section 865(j)(1) would be unnecessary and, indeed,

meaningless. The regulations that respondent would have us apply

were already in place prior to the Tax Reform Act of 1986. If

Congress intended those existing regulations to apply, section

865(j)(1) is a nullity.

The purpose behind section 865(j)(1) is reflected in The

General Explanation of the Tax Reform Act of 1986, prepared by

the Joint Committee on Taxation, which provides as follows:

The Act provides that regulations are to be
prescribed by the Secretary carrying out the purposes
of the Act's source rule provisions, including the
application of the provisions to losses from sales of
personal property * * *. It is anticipated that
regulations will provide that losses from sales of
personal property generally will be allocated
consistently with the source of income that gains would
generate but that variations of this principle may be
necessary. * * * [Staff of Joint Comm. on Taxation,
 - 14 -

General Explanation of the Tax Reform Act of 1986, at
922-923 (J. Comm. Print 1987) (General Explanation).]

When Congress directs that regulations be promulgated to

carry out a statutory purpose, the fact that regulations are not

forthcoming cannot be a basis for thwarting the legislative

objective. It is well established that the absence of

regulations is not an acceptable basis for refusing to apply the

substantive provisions of a section of the Internal Revenue Code.

See, e.g., Estate of Neumann v. Commissioner, 106 T.C. 216, 221

(1996); H Enters. Intl., Inc. v. Commissioner, 105 T.C. 71, 82

(1995); First Chicago Corp. v. Commissioner, 88 T.C. 663, 669

(1987), affd. 842 F.2d 180 (7th Cir. 1988); Occidental Petroleum

Corp. v. Commissioner, 82 T.C. 819, 829 (1984). In Estate of

Neumann v. Commissioner, supra at 221, for instance, we

determined that regulations were not a prerequisite to applying

the generation-skipping tax to certain transfers when the

relevant statutory language (sec. 7701(f)) provided: "'The

Secretary shall prescribe such regulations as may be necessary or

appropriate to prevent the avoidance of those provisions of this

title'". We concluded that Congress had not given the Secretary

the power to determine section 2663's application; i.e., whether

the general rule of section 2663 applied to cases such as the

taxpayer's. Rather, we explained that Congress had simply

authorized the Secretary to provide rules on how the section

should apply. Id.
 - 15 -

In Occidental Petroleum Corp. v. Commissioner, supra at 829,

we considered the effect on the alternative minimum tax of the

absence of regulations under section 58(h).6 We stated: "the

failure to promulgate the required regulations can hardly render

the new provisions of section 58(h) inoperative. We must

therefore do the best we can with these new provisions.

Certainly we cannot ignore them." Id. We held that the absence

of regulations did not preclude proper adjustments in respect of

the tax benefit rule, and we proceeded to determine those

adjustments in that case. We reasoned that Congress had intended

section 58(h) to provide a basis for how (as opposed to whether)

the alternative minimum tax should be applied in order to take

into account the tax benefit rule. See Estate of Neumann v.

Commissioner, supra at 220.

On brief, respondent argues that our decision in Occidental

Petroleum Corp. v. Commissioner, supra, is distinguishable for

several reasons. First, respondent contends that section 58(h)

explicitly provided that a particular rule (i.e., the tax benefit

rule) was to be adopted in the regulations, whereas "section

865(j) merely provides that regulations are to be promulgated

with respect to a particular subject matter but does not state or

imply what rules are to be adopted with respect thereto."

6
Sec. 58(h) provided that "The Secretary shall prescribe
regulations under which items of tax preference shall be properly
adjusted where the tax treatment giving rise to such items will
not result in the reduction of the taxpayer's tax under this
subtitle for any taxable years."
 - 16 -

Second, respondent maintains that the legislative intent

underlying section 58(h) was well documented in the committee

reports accompanying the enactment of that section, while no

reference is made to section 865(j) in the relevant committee

reports. Finally, respondent asserts that contrary to the

instant case there were no controlling preexisting regulations in

Occidental Petroleum Corp.

Respondent's arguments are unpersuasive. First, we conclude

that Congress did intend that regulations promulgated pursuant to

section 865(j) would embody a "particular rule"; i.e., residence-

based sourcing would generally be used for losses realized on the

sale of noninventory personal property. Second, respondent's

reliance on the absence of any mention of section 865(j) in the

committee reports is erroneous, since Congress articulated the

overall purpose behind section 865 in the legislative history.

See supra pp. 8-9. In addition, the General Explanation confirms

that it was expected that losses generally would be sourced

similarly to gains. Although the General Explanation does not

technically rise to the level of legislative history, we have

nonetheless stated that "We are not unmindful of the fact that

both the Supreme Court, and this Court, have relied upon the

General Explanation in analyzing tax statutes * * * and that the

General Explanation is entitled to great respect". Rivera v.

Commissioner, 89 T.C. 343, 349 n.7 (1987).
 - 17 -

In the instant case, we must do "the best we can" in

applying section 865 and the policy underlying it to a situation

involving a loss realized by a U.S. resident on the sale of

noninventory personal property. Certainly, we are not free to

ignore section 865 simply because the Secretary has delayed

promulgating the appropriate regulations. Occidental Petroleum

Corp. v. Commissioner, supra at 829. In enacting section 865,

Congress determined that "the residence of the seller generally

is the location of much of the underlying activity that generates

income derived from sales of personal property". H. Rept. 99-

426, supra at 360, 1986-3 C.B. (Vol. 2) at 360. Section

865(j)(1) directs the Secretary to promulgate regulations to

carry out the purpose of section 865; i.e., that gains and losses

on the sale of noninventory personal property generally are

sourced at the residence of the seller.

The Explanation of Provisions accompanying the proposed

regulations states that "Section 1.865-2(a) provides the general

rule that stock losses are allocated in the same manner as stock

gains * * *. Thus, stock loss generally is allocated to the

residence of the seller." 61 Fed. Reg. 35697 (July 8, 1996)

(emphasis added). Moreover, the proposed regulations, if adopted

in their current form, would source petitioner's Paty stock loss

at the residence of the seller; i.e., in the United States. See

sec. 1.865-2(a)(1), (e)(2)(i), Proposed Income Tax Regs., 61 Fed.

Reg. 35696, 35697-35700 (July 8, 1996).
 - 18 -

Respondent has not provided, nor have we found, any reason

that would preclude application of the general rule articulated

in section 865(a) to the facts in this case. Applying this

general rule of residence-based sourcing, we hold that the loss

realized by petitioner on the sale of its Paty stock constitutes

a U.S. source loss for purposes of computing petitioner's foreign

tax credit limitation pursuant to section 904(a).7

Decision will be entered

under Rule 155.

7
We emphasize the narrow scope of our decision herein. Our
opinion does not hold that sec. 865 requires that losses realized
on the disposition of noninventory personal property must always
be sourced at the residence of the seller. To the contrary, we
recognize, and the General Explanation accompanying the enactment
of sec. 865 confirms, that exceptions to the general rule of
residence-based sourcing may be appropriate to prevent abuse.
See Staff of Joint Comm. on Taxation, General Explanation of the
Tax Reform Act of 1986, at 923 (J. Comm. Print 1987).