UNITED STATES TAX COURT

T.C. Memo. 2001-112

UNITED STATES TAX COURT

ANDREW G. AND CECILIA M. VAJNA, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5038-96.

Filed May 10, 2001.

Held: Respondent’s motion for leave to file

amended answer under Rule 41(a), Tax Court Rules of

Practice and Procedure, granted.

Ronald L. Blanc, James P. Joseph, Brad D. Brian, Michael R.

Doyen, Joseph S. Klapach, Ted W. Lieu, and Christopher S. Rizek,

for petitioners.

David J. Mungo and Katherine H. Ankeny, for respondent.

- 2 MEMORANDUM OPINION

NIMS, Judge:

Procedural Background

This matter is before the Court on respondent’s Motion for

Leave To File Amended Answer.

Such motion was filed on October

3, 2000, and respondent’s proposed amended answer was lodged as

of the same date.

On October 23, 2000, petitioners filed an

opposition to respondent’s motion.

Thereafter, on November 15,

2000, a hearing was held to address respondent’s motion and

petitioners’ objections.

The Court requested posthearing

briefing with respect to a particular issue raised by the

contentions and exhibits presented.

Accordingly, opening briefs

were filed in December of 2000, and reply briefs were filed in

January of 2001.

It is on the basis of these aforementioned

moving papers and subsequent submissions, written and oral, that

we decide respondent’s motion.

Factual information drawn from

such materials is accepted solely for the purpose of considering

the pending motion, and recitations thereof set forth below do

not constitute findings of fact in this case1.

In the notice of deficiency issued to petitioners in

December of 1995, respondent determined, among other things, that

petitioners received subpart F income which was not reported on

their returns for the taxable years 1988 and 1989.

1

More

Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect at all relevant

times hereunder. All Rule references are to the Tax Court Rules

of Practice and Procedure.

- 3 specifically, as relevant to the instant proceeding, respondent

adjusted petitioners’ income to include 50 percent of alleged

subpart F income received by Carolco Investments B.V. (CIBV), a

Netherlands entity, on the grounds that CIBV was a controlled

foreign corporation in which petitioners owned 50 percent of the

stock.

The remaining 50 percent was allocated to Mario F.

Kassar, petitioner in a related case at docket No. 5195-96.

This

position was maintained in respondent’s original answer.

Respondent now seeks in paragraph 7 of the amended answer to

attribute to petitioners 100 percent of CIBV’s purported subpart

F income for 1989, with a corresponding increase in the

deficiency and accuracy-related penalty due for that year.

Respondent’s alleged basis for doing so is the claim that on

December 30, 1989, the 50 percent of CIBV shares formerly owned

by Mr. Kassar was transferred to Trust-en Administratiekantoor

Nestor B.V. (Nestor), another Netherlands corporation, which

respondent avers was owned or controlled by petitioners.

At the hearing held on November 15, 2000, counsel for

petitioners represented that his clients objected to respondent’s

proposed amended answer only with respect to the allegations set

forth in paragraph 7 thereof.

Hence, there is no barrier to our

granting respondent’s motion in so far as it relates to items

other than those detailed in paragraph 7.

As regards paragraph

7, we conclude, for the reasons explained below, that

respondent’s motion should be granted on this point as well.

- 4 Procedural Standard--Leave To Amend

Rule 41(a) provides in effect that after the pleadings are

closed, “a party may amend a pleading only by leave of Court or

by written consent of the adverse party, and leave shall be given

freely when justice so requires.”

Like rule 15(a) of the Federal

Rules of Civil Procedure, from which it is derived, Rule 41(a)

reflects “a liberal attitude toward amendment of pleadings.”

60

T.C. 1089 (explanatory note accompanying promulgation of Rule

41).

The U.S. Supreme Court has interpreted the “freely given”

language of the civil rule as follows:

If the underlying facts or circumstances relied upon by

a plaintiff may be a proper subject of relief, he ought

to be afforded an opportunity to test his claim on the

merits. In the absence of any apparent or declared

reason--such as undue delay, bad faith or dilatory

motive on the part of the movant, repeated failure to

cure deficiencies by amendments previously allowed,

undue prejudice to the opposing party by virtue of

allowance of the amendment, futility of amendment,

etc.--the leave sought should, as the rules require, be

“freely given.” * * * [Foman v. Davis, 371 U.S. 178,

182 (1962).]

Accordingly, leave to amend should typically be supported by the

presence of a colorable position and the absence of undue

prejudice.

We consider the substantive law and the factual

circumstances underlying respondent’s motion in light of the

foregoing procedural standard.

- 5 Substantive Principles--Taxation of Subpart F Income

Section 951 sets forth the operative rules governing

treatment of subpart F income and provides in pertinent part as

follows:

SEC. 951.

AMOUNTS INCLUDED IN GROSS INCOME OF UNITED

STATES SHAREHOLDERS.

(a) Amounts Included.-(1) In general.--If a foreign corporation

is a controlled foreign corporation for an

uninterrupted period of 30 days or more during any

taxable year, every person who is a United States

shareholder * * * of such corporation and who owns

(within the meaning of section 958(a)) stock in

such corporation on the last day, in such year, on

which such corporation is a controlled foreign

corporation shall include in his gross income, for

his taxable year in which or with which such

taxable year of the corporation ends-(A) the sum of-(i) his pro rata share * * * of the

corporation’s subpart F income for such

year * * *

Section 957 then goes on to define a controlled foreign

corporation (CFC) as a foreign corporation in which more than 50

percent of the total combined voting power or total value of

stock is owned by United States shareholders on any day during

the corporation’s taxable year.

Hence, two issues relevant in determining petitioners’

liability for taxes on income received by CIBV are:

(1) The

ownership of CIBV for purposes of evaluating its status as a CFC

in 1989; and (2) the ownership of CIBV for purposes of allocating

- 6 to such owners a pro rata share of subpart F income.

Section

958(a) gives the following guidance on the question of stock

ownership:

SEC. 958(a).

Direct and Indirect Ownership.--

(1) General rule.--For purposes of this

subpart * * *, stock owned means-(A) stock owned directly, and

(B) stock owned with the

application of paragraph (2).

(2) Stock ownership through foreign

entities.--For purposes of subparagraph (B) of

paragraph (1), stock owned, directly or

indirectly, by or for a foreign corporation,

foreign partnership, or foreign trust or foreign

estate * * * shall be considered as being owned

proportionately by its shareholders, partners, or

beneficiaries. Stock considered to be owned by a

person by reason of the application of the

preceding sentence shall, for purposes of applying

such sentence, be treated as actually owned by

such person.

In addition, regulations promulgated under section 958

provide rules of application supplementing the statutory text:

Amount of interest in foreign corporation, foreign

partnership, foreign trust, or foreign estate. The

determination of a person’s proportionate interest in a

foreign corporation, foreign partnership, foreign

trust, or foreign estate will be made on the basis of

all the facts and circumstances in each case.

Generally, in determining a person’s proportionate

interest in a foreign corporation, the purpose for

which the rules of section 958(a) and this section are

being applied will be taken into account. Thus, if the

rules of section 958(a) are being applied to determine

the amount of stock owned for purposes of section

951(a), a person’s proportionate interest in a foreign

corporation will generally be determined with reference

to such person’s interest in the income of such

corporation. If the rules of section 958(a) are being

- 7 applied to determine the amount of voting power owned

for purposes of section * * * 957, a person’s

proportionate interest in a foreign corporation will

generally be determined with reference to the amount of

voting power in such corporation owned by such person.

However, any arrangement which artificially decreases a

United States person’s proportionate interest will not

be recognized. * * * [Sec. 1.958-1(c)(2), Income Tax

Regs.]

Regulations under section 957 similarly state that in

analyzing CFC status:

Any arrangement to shift formal voting power away from

United States shareholders of a foreign corporation

will not be given effect if in reality voting power is

retained. The mere ownership of stock entitled to vote

does not by itself mean that the shareholder owning

such stock has the voting power of such stock for

purposes of section 957. * * * [Sec. 1.957-1(b)(2),

Income Tax Regs.]

Case law has likewise reiterated in dealing with CFC status

questions that “mere technical compliance with section 957(a)” is

insufficient to exclude taxpayers from its application and that

the “50-percent test of section 957(a) was intended to exclude

from the definition of controlled foreign corporations only those

foreign corporations which are not subject to the dominion and

control of the United States shareholders.”

Estate of Weiskopf

v. Commissioner, 64 T.C. 78, 93 (1975), affd. without published

opinion 538 F.2d 317 (2d Cir. 1976); see also Kraus v.

Commissioner, 59 T.C. 681, 692 (1973), affd. 490 F.2d 898 (2d

Cir. 1974); Garlock, Inc. v. Commissioner, 58 T.C. 423, 433

(1972), affd. 489 F.2d 197 (2d Cir. 1973).

- 8 Factual Circumstances

In light of the foregoing principles, we turn to the facts

before us.

From 1986 through most of 1989, shares of CIBV were

distributed as follows (with intermediate controlled entities

omitted for purposes of simplification):

Mario F. Kassar (a United States resident)

Kassar Family Trust (a Jersey entity)

Andrew G. Vajna (a United States resident)

Mong Family Trust (a Hong Kong entity)

24.95 percent

25.05 percent

24.95 percent

25.05 percent

(Mr. Mong Hin Yan was the father of petitioner Cecilia M.

Vajna.)

CIBV, in turn, owned approximately 75 percent of Carolco

Pictures, Inc. (CPI), a Delaware corporation involved in the

business of international motion picture distribution.

Then, in late 1989, it was decided to effect a buyout

transaction whereby Mr. Kassar and the Kassar Family Trust would

obtain control of CPI.

In preparation therefor, the CIBV shares

controlled by Mr. Kassar and the Kassar Family Trust were

transferred to Beheer-en Beleggingsmaatschappij Petina B.V.

(Petina), a Netherlands corporation also controlled by Mr. Kassar

and the Kassar Family Trust.

As originally contemplated, the

buyout was then to proceed as follows.

On or before December 29,

1989, CIBV was to sell all of its CPI stock to Petina and third

parties and was to receive in return monetary compensation (cash

and notes) in excess of $100 million plus the 50 percent of CIBV

- 9 shares held by Petina (essentially a redemption).

After these

transfers, Petina would control CPI and Mr. Vajna and the Mong

Family Trust would own 100 percent of CIBV.

However, due to an alleged technicality of Dutch law that

prevented CIBV from acquiring its own shares from Petina prior to

the close of 1989, an amended sales agreement was entered as of

December 29, 1989.

Pursuant to this revised arrangement and in

lieu of transferring its CIBV stock to CIBV, Petina agreed to

issue a nonrecourse promissory note to CIBV in the amount of

$99,253,000 and to grant to CIBV an option to purchase the

shares.

The option enabled CIBV to acquire the subject stock,

once the aforementioned legal impediment was removed, in exchange

for canceling the $99,253,000 note.

The amended sales

arrangement additionally provided that Petina would transfer the

CIBV shares to Nestor, subject to CIBV’s option to purchase.

In

return, Nestor would assume the $99,253,000 note obligation,

relieving Petina of all further liability.

Both the transaction

between CIBV and Petina and that between Petina and Nestor took

place on December 30, 1989.

Consequently, as of December 30, 1989, Petina controlled

CPI, and ownership of CIBV was divided among Mr. Vajna, the Mong

Family Trust, and Nestor in the manner set out below:

Andrew G. Vajna

Mong Family Trust

Nestor

24.95 percent

25.05 percent

50 percent

(499 shares)

(501 shares)

(1000 shares)

- 10 The option was thereafter exercised and the redemption of CIBV

shares from Nestor completed on December 20, 1990.

Mr. Vajna

then owned 49.9 percent of CIBV and the Mong Family Trust owned

50.1 percent.

Given this scenario, it has been respondent’s position from

the outset that, for purposes of subpart F, ownership of the Mong

Family Trust and the Kassar Family Trust should be attributed to

petitioners and to Mr. Kassar, respectively.

Respondent’s

amended answer now seeks to attribute ownership of Nestor to

petitioners as well.

Respondent asserts that ownership of Nestor

bears upon the status of CIBV as a CFC on and after December 30,

1989, and upon the proper allocation of CIBV’s subpart F income.

At the hearing held on November 15, 2000, counsel for petitioners

strenuously objected that respondent was engaging in a “fishing

expedition”.

During such proceeding, the principal evidence

offered by respondent that purported to establish a link between

Mr. Vajna and Nestor was two documents entitled “IRREVOCABLE

PROXY AND POWER OF ATTORNEY”.

On December 30, 1989, the same

date as the buyout was effected, Nestor executed these grants in

favor of Mr. Vajna and the Mong Family Trust, respectively.

operative part, the documents read:

The undersigned hereby irrevocably appoints and

constitutes Mr. Andrew G. Vajna [or Bankers Trust

International Services, Ltd., as trustee of the Mong

Family Trust] as its proxy and attorney-in-fact to

exercise, do, and perform any act, right, power, duty,

In

- 11 or obligation whatsoever that the undersigned now has

or may in the future have the legal right, power, or

capacity to do, exercise, or perform as holder of Four

Hundred and Ninety Nine (499) [or Five Hundred and One

(501) in the proxy to the Mong Family Trust] shares of

the capital stock of Carolco Investments, B.V., a

corporation organized under the laws of The Netherlands

(“CIBV”), held by the undersigned, including voting

said shares, granting or withholding consents,

authorizations or demands with respect thereto, and any

other action that may be taken by the record and

beneficial owner thereof, with power of substitution

and with full power to act for the undersigned in its

name, place and stead, in the same manner, and to the

same extent and effect, that the undersigned might if

it were personally present and acting.

Application of Rule 41 Standard in Light of Law and Facts

A.

Presence of Colorable Position

On the basis of the foregoing, we make the following

observations as regards the potential merit of respondent’s

position.

The disputed portion of respondent’s amended answer

aims to tax petitioners under subpart F on a greater percentage

of the income received by CIBV.

Resolution of such issue, if it

is allowed to be raised, will depend in significant part both on

the status of CIBV as a section 957 CFC and on the ownership of

CIBV for purposes of the section 951 income allocation rules.

Respondent’s revised allegations with respect to these two

elements rest, first, on the claim that Nestor was record owner

of 50 percent of CIBV shares after the buyout and, second, on the

contention that Nestor’s ownership should be attributed to

petitioners in applying both section 957 and section 951(a).

- 12 Since the parties are in apparent consensus, and the evidence

reflects, that 50 percent of CIBV stock was titled in Nestor

after the buyout, we turn to whether there exists grounds for

respondent’s arguments concerning petitioners’ deemed ownership.

Regulations indicate that voting power is the primary

consideration in deciding ownership for purposes of CFC status.

Hence, the linkage between Nestor and petitioners established by

the above-quoted proxies lends support to respondent’s claims

regarding CIBV’s CFC status on and after December 30, 1989.

With respect to section 951 attribution, the regulatory test

focuses on ascertaining the extent of a party’s interest in the

income of the CFC.

The regulations further expressly provide

that “any arrangement which artificially decreases a United

States person’s proportionate interest will not be recognized.”

Sec. 1.958-1(c)(2), Income Tax Regs.

Based on this standard, we

must conclude that the proxies are likewise pertinent to, and

potentially supportive of respondent’s position on, the question

of a proper section 951 allocation.

The regulations indicate

that a person could in some circumstances be deemed to hold an

interest in income that might, as a formal matter, have resided

in someone else.

Here, if Mr. Vajna and the Mong Family Trust possessed 100

percent of the voting power in CIBV (directly or by proxy), and

if it were decided that the Mong Family Trust must be equated

- 13 with petitioners, then Mr. Vajna was in a position to control or

prevent any income distribution that would or could be made by

CIBV.

The Nestor arrangement might thus be construed to do no

more than artificially or formally decrease petitioners’ actual

interest in CIBV’s receipts.

Furthermore, the language of the proxies used to describe

the rights granted to the proxy holder is extremely broad.

The

terms certainly encompass more than voting power and do not

foreclose an interpretation that would include the right to

income distributions.

In this connection, we note that the

broad, irrevocable, presently operative nature of these proxies

renders unpersuasive petitioners’ attempts to find an analog in

the limited agency conveyed by a typical voting proxy or the

prospective rights represented by a mere option.

Accordingly, we believe that there exists colorable support,

particularly in the proxy documents, that renders respondent’s

position more than a “fishing expedition”.

B.

Absence of Undue Prejudice

We must next weigh the possible prejudice to petitioners

that could be caused by even a potentially meritorious argument.

Although we are sympathetic to petitioners’ protests regarding

the large increase in deficiency, we find these concerns to be

mitigated by at least two principal factors:

(1) The centrality

of Nestor’s role to a complete and accurate resolution of the

- 14 entire subpart F issue as it relates to CIBV, and (2) the closely

proximate relationship of the new contentions to those raised in

the original notice of deficiency and answer.

As to the first point listed, and particularly in light of

the fact that Mr. Kassar is likely to contest the whipsaw

allocation to him of 50 percent of CIBV’s income, we fail to see

how a fair and satisfactory outcome can be reached in these two

related cases without addressing Nestor.

As regards the second

point, ownership of CIBV for purposes of determining both CFC

status and section 951 attribution has been at issue from the

earliest stages of this dispute.

Hence, petitioners were already

faced with needing to marshal evidence related to these ownership

matters.

Such circumstance, especially when coupled with the

ample time remaining to prepare for trial, which is scheduled to

begin October 22, 2001, and with the fact that respondent will

bear the burden of proof as to the increased deficiency, deprives

arguments of surprise or prejudicial delay of any overriding

force.

We therefore conclude that the interests of justice will

be better served by permitting amendment and thereby being in a

position to decide this case, and the related case of Mr. Kassar,

consistently and on the merits of all relevant evidence.

Lastly, for the sake of completeness, we note that

petitioners’ computational arguments disregard possible

- 15 interpretations of the transactions involved, are premature, and

cannot substitute for analysis of the underlying substantive

issues.

To reflect the foregoing,

An appropriate order will be

issued granting respondent’s motion

for leave to file amended answer.