dissenting: I disagree with the majority’s conclusion that Brown Cayman Ltd’s. (Brown Cayman’s) share of partnership income from Brinco is subpart F income; therefore, I respectfully dissent.
The majority relies on three reasons to reach the holding that the income in question is subpart F income: (1) A technical analysis under subchapter K of the Code; (2) application of the aggregate theory of partnerships; and (3) support from the language of section 954(d)(1). Judge Chiechi, in her concurrence, explains the flaw in two of these three reasons, namely, in reasons (1) and (3). In this dissent I explain why the remaining reason, reason (2) (the application of the aggregate theory of partnerships) is flawed.
The controversy involved in this case involves a controlled foreign corporation (Brown Cayman) that was a member of a partnership (Brinco) that earned income by acting as a commission purchasing agent on behalf of the parent (Brown Group International) of the controlled foreign corporation. In reaching its conclusion, the majority would disregard Brinco as an entity and treat Brown Cayman as if it had performed the activities of Brinco. I disagree. In my opinion, the existence of Brinco should be respected, and the commission income Brinco received should be characterized at the partnership level.
“Subpart F income”, as defined under section 952(a), is the sum of four specifically defined types of income. Only one type of subpart F income, specifically “foreign base company income”, is involved in this case. “Foreign base company income”, as defined under section 954(a), is the sum of five specifically defined types of income. Only one type of foreign base company income, specifically “foreign base company sales income”, is involved in this case.
Section 954(d)(1) defines “foreign base company sales income” as follows:
SEC. 954(d). Foreign Base Company Sales Income.—
(1) In general. — For purposes of subsection (a)(2), the term “foreign base company sales income” means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where—
(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and
(B) the property is sold for use, consumption, or disposition outside such foreign country or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.
A “related person” is defined in section 954(d)(3), as in effect for the taxable year in issue, as follows:
(3) Related person defined. — For purposes of this section, a person is a related person with respect to a controlled foreign corporation, if—
(A) such person is an individual, partnership, trust, or estate which controls the controlled foreign corporation;
(B) such person is a corporation which controls, or is controlled by, the controlled foreign corporation; or
(C) such person is a corporation which is controlled by the same person or persons which control the controlled foreign corporation.
For purposes of the preceding sentence, control means the ownership, directly or indirectly, of stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote. For purposes of this paragraph, the rules for determining ownership of stock prescribed by section 958 shall apply.
[Emphasis added.]
Here, there is no question but that Brown Cayman is a controlled foreign corporation and that Brown Group International is a U.S. shareholder of a controlled foreign corporation. Thus, Brown Group International (and ultimately the affiliated group of which it is a member) must include in income the foreign base company sales income earned by Brown Cayman. But, as hereafter explained, Brown Cayman did not have foreign base company sales income.
In the elaborate detailing of section 954(d)(1), Congress required that, in order for a controlled foreign corporation to have foreign base company sales income, each of the following elements must be present: (1) A purchase or sale, (2) of personal property, (3) from, to, or on behalf of a related person, and (4) such personal property must be manufactured outside the controlled foreign corporation’s country of incorporation, and (5) the sale must be for use, consumption, or disposition outside such controlled foreign corporation’s country of incorporation. In the instant case four of the five elements are present, namely, the first two and last two elements. But the third element is not present because the purchase of the footwear was not made from, to, or on behalf of a related person. Rather, the purchase in this case was arranged by Brinco from third parties on behalf of Brown Group International, a party unrelated to Brinca.
As to the third element, the majority does not claim there was a purchase of personal property from or to related parties. Rather, the majority asserts that there was a purchase on behalf of a related person by treating Brown Cayman as if it did the purchasing of footwear, through Brinco, on behalf of Brown Group International.1 The majority’s assertion is erroneous because Brinco is not a sham. In fact, it is undeniable that Brinco was formed and structured as a partnership, at least in part, for substantial business purposes. Further, the form of all of the partnership’s (Brinco’s) transactions involved reflect their substance.
For tax purposes, there are two different ways of viewing a partnership. A partnership may be viewed as an aggregation of its partners, each of whom directly owns an interest in partnership assets and operations, or as a separate entity, in which separate interests are owned by each of its partners. By disregarding Brinco, the majority uses an aggregate partnership approach. Using the aggregate approach, the majority attributes the partnership’s (Brinco’s) activities, and not merely the character of the partnership income, to its partner (Brown Cayman).
It is noteworthy that in defining a related person, section 954(d)(3) provides that a partnership that controls a foreign corporation is a related person, and thus the income derived in connection with the purchase or sale of personal property between the two entities (that is, the controlling partnership and controlled foreign corporation) is treated as foreign base company sales income. Had Congress viewed a partnership as an aggregation of its partners (rather than as a separate entity), then there would have been no need to include a partnership in the definition of a related person. Instead, the determination of a related person would be made separately as to each partner depending on whether that partner was related to the entity with whom the partnership purchased or sold personal property.
As stated, I believe the majority’s aggregate approach is erroneous. The process of characterizing partnership income, for tax purposes, is a two-part process: First, the partnership is treated as an entity in whose hands the partnership income is characterized, and then the partnership is treated as a conduit (an aggregate concept) through which the income received is passed on to the partners in accord with their distributive shares. Treating the partnership (Brinco) as an entity in whose hands the commission income is to be characterized produces a result that the income in question is not foreign base company sales income, and hence is not subpart F income.
No court has addressed the issue of whether, in the context of subpart F of the Code, section 702(b) should be interpreted as determining the character of income at the partner level (aggregate approach) or at the partnership level (entity approach). However, as will be later discussed, regulations issued on December 30, 1994, permit the Internal Revenue Service (Service) to treat, in certain situations, a partnership as an aggregation of its partners, in whole or in part, as appropriate to carry out the provision of the Code or regulations thereunder with respect to transactions that occur on or after December 30, 1994. The transactions involved herein occurred prior to that date.
For the most part, the cases that have directly considered whether partnership items should be characterized at the partner or partnership level have generally concluded that the characterization question should be resolved at the partnership level. See 1 McKee et al., Federal Taxation of Partnerships and Partners, par. 9.01[4][a], at 9-19 (2d ed. 1990) (the authors also note that partnership-level characterization is virtually required by the overall sense of the partnership taxation statutory framework).
The U.S. Supreme Court has stated that, for purposes of calculating partnership income, “the partnership is regarded as an independently recognizable entity apart from the aggregate of the partners”. United States v. Basye, 410 U.S. 441, 448 (1973). The Court also noted:
The legislative history indicates, and the commentators agree, that partnerships are entities for purposes of calculating and filing informational returns but that they are conduits through which the taxpaying obligation passes to the individual partners in accord with their distributive shares. [Id. n.8; citations omitted.]
Recent cases cite United States v. Basye, supra, in holding that characterization of partnership income derived from the sale of property takes place at the partnership level. For example, in Pleasant Summit Land Corp. v. Commissioner, 863 F.2d 263 (3d Cir. 1988), affg. in part and revg. in part T.C. Memo. 1987-469, the Court of Appeals upheld our factual finding that the sale of real estate held by a partnership was properly characterized as a capital gain. In holding that such characterization takes place at the partnership level, the Court of Appeals quoted Basye and concluded: “we must make our analysis of the investment from the point of view of the partnership”. Id. at 272.2
In Barham v. United States, 301 F. Supp. 43 (M.D. Ga. 1969), affd. 429 F.2d 40 (5th Cir. 1970), the District Court held that, where the trade or business of a joint venture was the purchase, development, and sale of real estate, the partner-taxpayer’s distributive share of income received from the sale of real estate was not entitled to capital gain treatment even though the partner was not engaged in the real estate business. Id. at 46-49.3 The court referred to section 702(b) as the “conduit rule” and stated:
The clear inference to be drawn from the Code sections and the regulation is that, as a general rule, for the purpose of determining the nature of an item of income, deduction, gain, loss or credit * * * the partnership is to be viewed as an entity and such items are to be viewed from'the standpoint of the partnership (or joint venture) rather than from the standpoint of each individual member. * * * [Id. at 46.]
The court added:
It follows that in section 1221(1) the words “his trade or business” mean the trade or business of the partnership, even though under section 701 partnerships are not liable for income tax. * * * [Idl\
In McManus v. Commissioner, 583 F.2d 443 (9th Cir. 1978), affg. 65 T.C. 197 (1975), the Court of Appeals affirmed this Court’s holding that a section 1033 election must be made at the partnership level. The Court of Appeals rejected the taxpayer’s argument that the partnership was not a taxable entity, stating:
While it is true that a partnership is not liable for tax * * * [it] is required to file returns and the partners are required to conform their individual returns to the partnership returns. If each partner could determine his share of the partnership income separately, confusion would result, confusion which Congress meant to avoid * * * [Id. at 448; citation omitted.]
In Davis v. Commissioner, 74 T.C. 881 (1980), affd. 746 F.2d 357 (6th Cir. 1984), we held that the special allocation to a partner-taxpayer of royalties paid to the partnership retains its character as a capital gain under section 631(c) in the hands of the taxpayer. We reviewed section 702(b) and stated: “This language has been consistently interpreted to mean that the character of partnership income is determined at the partnership level”. Id. at 905-906 (citing United States v. Basye, 410 U.S. 441 (1973); Podell v. Commissioner, 55 T.C. 429 (1970); Grove v. Commissioner, 54 T.C. 799 (1970); sec. 1.702-1(b), Income Tax Regs.).
This Court and several Courts of Appeals have addressed the issue of profit motive, for purposes of section 162, with respect to partnerships. All have held that such characterization is to be made at the partnership level. For example, in Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984), affg. 78 T.C. 471 (1982), the court held that, in determining whether a partner-taxpayer was entitled to any claimed deductions which were attributable to cash paid by the partnership for a movie, the profit-motive analysis was properly made at the partnership level.4
In Goodwin v. Commissioner, 75 T.C. 424 (1980), affd. without published opinion 691 F.2d 490 (3d Cir. 1982), this Court also held that profit motive under section 162 is properly applied at the partnership level, and we noted that section 702(b) “has been held to require that the character of the items comprising the partnership income or loss be determined at the partnership level”. Id. at 436 (citing Davis v. Commissioner, 74 T.C. 881, 905-906 (1980), affd. 746 F.2d 357 (6th Cir. 1984); Miller v. Commissioner, 70 T.C. 448, 455-456 (1978); Podell v. Commissioner, 55 T.C. 429, 432-434 (1970); Grove v. Commissioner, 54 T.C. 799, 803-805 (1970)). In Goodwin v. Commissioner, supra at 437, we then concluded: “that in the context of section 162, the character of the deductions, i.e., whether they were incurred in the course of a trade or business, must be resolved at the partnership level.”
In addition, in Campbell v. United States, 813 F.2d 694 (5th Cir. 1987), the court held that the attribution of a loss to a trade or business for the purposes of section 172(d)(4) (which allows certain business deductions in calculating a net operating loss) must be made at the partnership level: “We have held that under section 702(b), partnership business deductions may be attributed to the individual partner-taxpayer only if such deductions were incurred in the partnership’s trade or business”. Id. at 695-696 (citing Tallal v. Commissioner, 778 F.2d 275, 276 (5th Cir. 1985), affg. T.C. Memo. 1984-486).
In Resnik v. Commissioner, 66 T.C. 74, 81 (1976), affd. per curiam without published opinion 555 F.2d 634 (7th Cir. 1977), we concluded that, under section 446(b), we must “first look at the partnership level to ascertain whether the prepayment of interest results in a distortion of income”. In so concluding, we reasoned:
The partnership return is more than just an information return. It has consequences that go beyond the mere disclosure to the Commissioner of profits of the enterprise * * * And in computing its net income under the revenue laws, it is generally the partnership, not the individual partner, that exercises the various options open to taxpayers in computing net income under the Code. * * * [Id. at 80-81 (quoting Scherf v. Commissioner, 20 T.C. 346, 347-348 (1953)).]
In Rev. Rul. 68-79, 1968-1 C.B. 310, the Service characterized as long-term capital gain a partner’s distributive share of capital gain upon the sale of securities because, even though the partner held his partnership interest for less than 6 months, the partnership held the securities longer than the requisite holding period. The ruling stated:
The character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share under paragraphs (1) through (8) of section 702(a) of the Code is determined at the partnership level. [Rev. Rul. 68-79, 1968-1 C.B. at 310; emphasis added; citation omitted.]
Similarly, the Service has ruled that characterization of ordinary loss under section 1231 must take place at the partnership level. Rev. Rul. 67-188, 1967-1 C.B. 216. Likewise, in Rev. Rul. 77-320, 1977-2 C.B. 78, the Service expressed the position that section 183 applies to partnerships at the partnership level.
In nearly every context in which the issue of characterization of partnership income is relevant to the facts of this case, this Court and other courts have concluded that the proper level for characterizing an item of income is at the partnership level. Applying the logic of these cases to the determination of foreign base company sales income, I would apply the entity theory of partnership taxation; that is, I would characterize the income involved herein at the partnership (Brinco’s) level. As a consequence, I would conclude that the income in question is not subpart F income.
I recognize that acceptance of my position will result in petitioner’s receiving a tax windfall because 100 percent of the commissions paid to Brinco by Brown Group International would be included in its cost of goods sold, whereas 88 percent of the commissions (which ultimately went to Brown Cayman) would not be taxed. But as the Court of Appeals for the Ninth Circuit has stated:
The Government asserts that in enacting subpart F Congress was more concerned with the nature of the income than the form of the entity-generating the income * * *
We find this argument unpersuasive. * * * Congress wrote the statute unambiguously to apply to subpart F income received from controlled “corporations” only. If the omission of income received from controlled partnerships has indeed created an unjustified loophole in the tax laws, the remedy lies in new legislation, not in judicial improvisation.
[MCA Inc. v. United States, 685 F.2d 1099, 1104-1105 (9th Cir. 1982).]
Petitioner may have found a hole in the dike, but the closing of the hole “calls for the application of the Congressional thumb, not the court’s.” Fabreeka Prods. Co. v. Commissioner, 294 F.2d 876, 879 (1st Cir. 1961), vacating and remanding 34 T.C. 290 (1960); see Hanover Bank v. Commissioner, 369 U.S. 672, 688 n.23 (1962). The Service may have closed the hole in the dike for partnership transactions that occur on and after December 30, 1994, but here, as previously stated, the transactions involved occurred prior to that date.
On December 30, 1994, the Service issued final regulations, section 1.701-2, Income Tax Regs., 60 Fed. Reg. 27 (Jan. 3, 1995), providing for an antiabuse rule under sub-chapter K of the Code. The rule permits the Service, in certain instances, to recast partnership transactions that make inappropriate use of the rules of subchapter K. In addition, and more pertinent to this case, section 1.701-2(e), Income Tax Regs., provides that the Service can treat a partnership as an aggregation of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Code or regulations thereunder, except to the extent that: (1) A provision of the Code or regulations prescribes the treatment of the partnership as an entity, and (2) that treatment and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by that provision.
The antiabuse rule is effective for all transactions involving a partnership that occur on or after May 12, 1994. The provisions permitting the Service to treat a partnership as an aggregation of its partners as appropriate to carry out the purpose of any provision of the Code are effective for all transactions involving a partnership that occur after December 29, 1994. The transactions involved herein occurred prior to November 2, 1986, and Brinco was dissolved on October 31, 1987.
Chabot and Laro, JJ., agree with this dissent.See majority op. p. 120, wherein the majority states:
Finally, we wish to dispose of one argument made by petitioner: viz, that, for the year in question, Brinco was not a related person with regard to Brown Cayman or International. That is true; nonetheless, it is irrelevant. Nothing here turns on whether Brinco is a related person with regard to either Brown Cayman or International. We are dealing here with that part of the definition of foreign base company sales income that involves “the purchase of personal property from any person on behalf of a related person”. Sec. 954(d)(1). The inquiry is whether Brown Cayman, through Brinco, purchased footwear on behalf of International. * * *
See also Simon v. Commissioner, 830 F.2d 499, 506-507 (3d Cir. 1987) (determination of whether an expense is deductible is dependent upon partnership’s motive, not by an individual’s purpose in joining the partnership), affg. T.C. Memo. 1986-156.
See also Estate of Freeland v. Commissioner, 393 F.2d 573, 584 (9th Cir. 1968) (“it is the intent of the partnership, and not of any individual partner, that is in issue according to the Internal Revenue Code”), affg. T.C. Memo. 1966-283; Podell v. Commissioner, 55 T.C. 429, 431-434 (1970) (holding that joint venture arrangement was to be treated as a partnership for tax purposes and that the character of real estate sales income was determined at the partnership level); Stivers v. Commissioner, T.C. Memo. 1973-244 (holding that the character of gains from sales of real estate by partnership was to be determined at the partnership level).
See also Polakof v. Commissioner, 820 F.2d 321, 323 (9th Cir. 1987) (“We agree with the Fifth and Eleventh Circuits that it is the dominant economic motive of the partnership, not that of the individual investors, that is determinative.”), affg. T.C. Memo. 1985-197; Tallal v. Commissioner, 778 F.2d 275, 276 (5th Cir. 1985) (“When the taxpayer is a member of a partnership, we have interpreted section 702(b) to require that business purpose must be assessed at the partnership level.”), affg. T.C. Memo. 1984-486; Madison Gas & Elec. Co. v. Commissioner, 633 F.2d 512, 517 (7th Cir. 1980) (expenses characterized as “pre-operational costs” of partnership even though general partner was already in the same business), affg. 72 T.C. 521 (1979).