Brown Group reversal: circuit court treats partnership as "unrelated" entity under Subpart F.

• Author: Benson, David M.

A corporation's distributive share of a partnership's earnings was held not to constitute subpart F income because the partnership was not a related person under the existing statute.

The Eighth Circuit has reversed the Tax Court's decision in Brown Group Inc., 102 TC 616 (1994), in which the Tax Court held, in a reversal of its own original decision in the case, that, applying the aggregate theory of partnerships advocated by the IRS, income earned by a Cayman Islands partnership should be treated as directly earned by its controlled foreign corporation (CFC) shareholder and, therefore, subject to current U.S. taxation.

In reversing the Tax Court's decision, the Appeals Court held:

* The Tax Court erred in ignoring the partnership entity in characterizing the Cayman Islands partnership's earnings as taxable subpart F income.

* The Cayman Islands corporation's distributive share of the Cayman Islands partnership's earnings did not constitute subpart F income because the Cayman Islands partnership did not control the Cayman Islands corporation and, thus, was not a "related person" under Sec. 954(d) (3) as that statute existed in 1986.

Brown Group Inc. (BG), a publicly traded N.Y. corporation, was the common parent of an affiliated group of corporations. BG owned all the stock of a domestic subsidiary, Brown Group International (DS), which in turn owned all the stock of a Cayman Islands corporation, Brown Cayman Ltd. (FS). FS owned 88% of Brinco, a partnership that acted as purchasing agent for BG in Brazil. P, a U.S. citizen, owned 10% of Brinco through T.P. Cayman Ltd. (TPC). The remaining 2% ownership interest in Brinco was held by B, a citizen of Brazil. Brinco was dissolved at the end of October 1987.

The IRS determined that FS's distributive share of Brinco's earnings for the years at issue was foreign-base company sales income, includible as subpart F income in BG's consolidated gross income. Wholly owned by DS, FS was a CFC under Sec. 957(a). DS was considered a U.S. shareholder of a CFC and, therefore, had to include in gross income its pro rata share of any subpart F income earned by FS.

Following Rev. Rul. 89-72, the Service argued that general principles of the aggregate theory of partnership tax required that FS be treated as if its distributive share of Brinco's income had been earned directly from the source from which Brinco earned its income and that, therefore, FS's distributive share of Brinco's income would be subpart F...