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

• Author: Renfroe, Diane L.

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...