# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A28c62cd3ca3e9e93 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T.C. Memo. 1996-301 UNITED STATES TAX COURT INVERWORLD, INC., ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 27089-90, 27090-90, 3441-93, 3442-93, 3443-93, 3444-93. Filed June 27, 1996. Turner P. Smith, Nancy E. Delaney, and Robert D. Whoriskey, for petitioner in docket No. 27089-90. Turner P. Smith, Nancy E. Delaney, T. Barry Kingham, and Robert D. Whoriskey, for petitioner in docket No. 27090-90. Turner P. Smith and Nancy E. Delaney, for petitioners in docket Nos. 3441-93, 3442-93, 3443-93, and 3444-93. Jill Frisch, Peter J. Graziano, and Maria Stabile, for respondent. 1 The following cases are consolidated herewith for purposes of trial, briefing, and opinion: InverWorld, Inc., docket No. 3441-93; InverWorld, Ltd., docket Nos. 27090-90, 3443-93 and 3444-93; and InverWorld Holdings, Inc., docket No. 3442-93. - 2 CONTENTS I. STATEMENT OF ISSUES . . . . . . . . . . . . . . . . . . . . 8 A. Issues With Respect to LTD . . . . . . . . . . . . . 8 B. Issues With Respect to INC . . . . . . . . . . . . 10 C. Issues With Respect to Holdings . . . . . . . . . . 11 II. FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . A. Petitioners . . . . . . . . . . . . . . . . . . . . B. Petitioners' Returns . . . . . . . . . . . . . . . C. Creation of LTD . . . . . . . . . . . . . . . . . . D. Creation of INC . . . . . . . . . . . . . . . . . . E. Structure and Operation of LTD's Promotion, Service, and Sales . . . . . . . . . . . F. INC's Consulting Agreement With LTD . . . . . . . . G. Research . . . . . . . . . . . . . . . . . . . . . H. Financial Accounting and Client Statements for LTD I. IRS Audit During Spring 1987 . . . . . . . . . . . J. The Transition to MultiValores . . . . . . . . . . K. Accounting Firm Audit . . . . . . . . . . . . . . . L. LTD's Receipts . . . . . . . . . . . . . . . . . . 1. Management Fees . . . . . . . . . . . . . . . 2. Interest Income . . . . . . . . . . . . . . . a. U.S. Certificates of Deposit and Bank Deposits . . . . . . . . . . . . b. Loans . . . . . . . . . . . . . . . . . . c. Non-U.S. Certificates of Deposit and Term Deposits . . . . . . . . . . . . d. Pace Investments . . . . . . . . . . . . e. MMA II . . . . . . . . . . . . . . . . . 3. Currency Exchange Transactions Income . . . . a. Currency Swaps . . . . . . . . . . . . . b. Currency Transactions . . . . . . . . . . 4. Sales Commissions and Fees . . . . . . . . . . a. Currency Fund . . . . . . . . . . . . . . b. FEIM Fund . . . . . . . . . . . . . . . . c. Matric Fund . . . . . . . . . . . . . . . d. Inversat Fund . . . . . . . . . . . . . . e. TVA . . . . . . . . . . . . . . . . . . . f. Client Incorporation and Trust Creation . g. Legal Advice Income . . . . . . . . . . . h. Letters of Credit . . . . . . . . . . . . i. Foreign Exchange Investments . . . . . . j. Treasury Bills . . . . . . . . . . . . . k. Wires and Checks . . . . . . . . . . . . l. Gold and Silver Futures . . . . . . . . . m. Project Income . . . . . . . . . . . . . n. Income From Investments . . . . . . . . . 11 11 12 13 15 17 22 26 27 29 30 31 31 31 33 33 38 38 40 40 43 43 43 46 46 47 48 49 50 52 53 53 54 54 55 55 56 56 - 3 o. M. III. Other Commission Income/ Other Commissions and Fees . . . . . . . p. Other Income . . . . . . . . . . . . . . Amounts Subject to Withholding Tax . . . . . . . . 57 57 59 OPINION . . . . . . . . . . . . . . . . . . . . . . . . 62 A. Whether LTD Was Engaged in Trade or Business Within the United States . . . . . . . 62 1. Background . . . . . . . . . . . . . . . . . . 64 2. Section 1.864-4(c)(5)(i), Income Tax Regs., Engaged in a Banking Business Test . . . . . . 64 B. Whether Each Item of LTD's Income Was Effectively Connected . . . . . . . . . . . . . 104 1. Character and Source Rules . . . . . . . . . . 104 2. Application of the Character and Source Rules 106 a. Management Fees . . . . . . . . . . . . . 107 b. Service Fees . . . . . . . . . . . . . . 107 (1) U.S. Certificates of Deposit and Bank Deposits . . . . . . . . . 107 (2) Non-U.S. Certificates of Deposit and Term Deposits . . . . . . . . . 113 (3) Pace Investments . . . . . . . . . . 114 c. Interest Income . . . . . . . . . . . . . 116 (1) Loans . . . . . . . . . . . . . . . 116 (2) MMA II . . . . . . . . . . . . . . . 116 d. Currency Exchange Transactions Income (Currency Swaps and Currency Transactions) . . . . . . . 117 e. Sales Commissions and Fees . . . . . . . 118 (1) Currency Fund, FEIM Fund, and Matric Fund . . . . . . . . . . 118 (2) Inversat Fund . . . . . . . . . . . 121 (3) TVA . . . . . . . . . . . . . . . . 122 (4) Client Incorporation and Trust Creation, Legal Advice Income, and Letters of Credit . . . 124 (5) Foreign Exchange Investments . . . . 124 (6) Treasury Bills, Wires and Checks, Gold and Silver Futures, Project Income, Income from Investments, Other Commission Income, Other Commissions and Fees, and Other Income . . . . . . . . . . 125 3. Effectively Connected Income Rules . . . . . . 125 a. Introduction to the Rules . . . . . . . . 125 b. Section 1.864-4(c)(5), Income Tax Regs., Banking Activity Test . . . . 127 c. Section 864(c)(2)(A) Asset-use Test . . . 128 - 4 d. C. Section 864(c)(2)(B) Business-Activities Test . . . . . . . . 129 e. Section 864(c)(4)(B) Rules for Income From Sources Without the United States . 130 4. Application of the Effectively Connected Income Rules . . . . . . . . . . . . 135 a. Management Fees . . . . . . . . . . . . . 136 b. Service Fees . . . . . . . . . . . . . . 139 (1) U.S. Certificates of Deposit and Bank Deposits . . . . . . . . . 139 (2) Non-U.S. Certificates of Deposit and Term Deposits . . . . . . . . . 143 (3) Pace Investments . . . . . . . . . . 146 c. Interest Income . . . . . . . . . . . . . 149 (1) Loans . . . . . . . . . . . . . . . 149 (2) MMA II . . . . . . . . . . . . . . . 157 d. Currency Exchange Transactions Income (Currency Swaps and Currency Transactions) . . . . . . . 161 e. Sales Commissions and Fees . . . . . . . 164 (1) Foreign Source TVA Commissions . . . 165 (2) All Commissions and Fees Excepting the Foreign Source TVA Commissions . 166 Whether LTD and INC are Liable for Withholding Tax . . . . . . . . . . . . . . . . 170 1. Background . . . . . . . . . . . . . . . . . . 170 2. Withholding Tax on Interest . . . . . . . . . 171 a. Pre-1986 Act Years . . . . . . . . . . . 176 (1) Character and Source Rules for Interest . . . . . . . . . 176 (2) Taxation of Interest . . . . . . . . 179 b. Post-1986 Act Years . . . . . . . . . . . 180 (1) Character and Source Rules for Interest . . . . . . . . . . . . 180 (2) Taxation of Interest . . . . . . . . 181 3. Withholding Tax on Dividends . . . . . . . . . 183 a. Character and Source Rules for Dividends . . . . . . . . . . . . . . 183 b. Taxation of Dividends . . . . . . . . . . 183 4. Discussion of Interest . . . . . . . . . . . . 185 a. Pre-1986 Act Years . . . . . . . . . . . 185 (1) Application of the Character and Source Rules for Interest . . . 185 (2) Taxation of Interest . . . . . . . . 188 b. Post-1986 Act Years . . . . . . . . . . . 189 (1) Application of the Character and Source Rules for Interest . . . 189 (2) Taxation of Interest . . . . . . . . 190 - 5 D. E. F. G. 5. Discussion of Dividend Income . . . . . . . . 191 Whether LTD Is Entitled to Deductions . . . . . . . 194 1. Law . . . . . . . . . . . . . . . . . . . . . 194 2. Discussion . . . . . . . . . . . . . . . . . . 195 Whether Income Should Be Allocated Pursuant to Section 482 . . . . . . . . . . . . . . 199 1. Background . . . . . . . . . . . . . . . . . . 199 2. Law . . . . . . . . . . . . . . . . . . . . . 200 a. Section 482 in General . . . . . . . . . 200 b. The Section 482 Regulations . . . . . . . 203 3. Discussion . . . . . . . . . . . . . . . . . . 208 Remaining Issues . . . . . . . . . . . . . . . . . 231 1. Positions of the Parties . . . . . . . . . . . 231 2. Issues With Respect to LTD . . . . . . . . . . 232 3. Issues With Respect to INC . . . . . . . . . . 232 4. Issues With Respect to Holdings . . . . . . . 232 Additions to Tax . . . . . . . . . . . . . . . . . 233 1. Section 6651(a)(1) . . . . . . . . . . . . . . 233 2. Sections 6653(a)(1) and 6653(a)(1)(A) . . . . 237 3. Section 6655(a) . . . . . . . . . . . . . . . 241 4. Section 6656(a) . . . . . . . . . . . . . . . 241 5. Section 6661(a) . . . . . . . . . . . . . . . 243 MEMORANDUM FINDINGS OF FACT AND OPINION WELLS, Judge: Respondent determined deficiencies in and additions to InverWorld, Ltd.'s (LTD) withholding tax as follows: InverWorld, Ltd., Docket Nos. 27090-90, 3443-93 Additions to Tax Sec. Sec. 6653(a)(1) 6653(a)(2) Year Deficiency Sec. 6651 1984 1985 $4,891,617 10,119,885 $1,222,904 2,529,971 Year Deficiency Sec. 6651(a)(1) 1986 1987 13,506,793 733,420 3,376,698 183,355 675,340 36,671 Year Deficiency Sec. 6651(a)(1) Additions to Tax Sec. 6653(a)(1) 1988 1989 1,524,928 2,951,566 381,232 737,891 $244,581 505,994 1 $489,162 1,011,988 1 Additions to Tax Sec. Sec. 6653(a)(1)(A) 6653(a)(1)(B) 76,246 --- Sec. 6656 1 1 Sec. 6656 1,350,679 73,342 Sec. 6656 152,493 295,157 - 6 1 50 percent of the interest due on the deficiency. Respondent determined deficiencies in and additions to LTD's Federal income taxes as follows:2 InverWorld, Ltd., Docket No. 3444-93 Additions to Tax Tax Year Sec. Ended 6656 June 30, 1987 June 30, 1988 Sec. Sec. Sec. Sec. 6653(a)(1)(B) 6655 Deficiency 6651(a)(1) 6653(a)(1)(A) $2,060,490 2,299,853 $515,123 574,963 $103,025 114,993 1 1 $101,169 128,503 $206,049 229,985 2 Respondent sent LTD a notice of liability for withholding tax and a notice of deficiency in corporate income tax, each dated Sept. 7, 1990, for its taxable years ended 1984, 1985, and 1986. LTD timely filed a petition with this Court contesting respondent's determinations in the notice of liability. LTD attached the notice of liability to its petition but did not attach the notice of deficiency. In its petition, LTD did not refer to or dispute any of the deficiencies in corporate income tax determined in the notice of deficiency. Because LTD failed to contest the determinations in the notice of deficiency, respondent, on Feb. 6, 1991, assessed the amounts of the tax, additions to tax, and interest for LTD's taxable years ended 1984, 1985, and 1986, as determined in the notice of deficiency. After the period for filing a petition with respect to the notice of deficiency had expired, LTD filed a motion for leave to file amendments to its petition contesting the notice of liability, pursuant to Rule 41(a). In InverWorld, Ltd. v. Commissioner, 98 T.C. 70 (1992), affd. 979 F.2d 868 (D.C. Cir. 1992), we held, inter alia, that, because each notice must be considered independently for purposes of jurisdiction, this Court did not acquire jurisdiction over the corporate income tax deficiencies determined in the notice of deficiency by virtue of a petition which contested only the withholding tax determinations in the notice of liability. Respondent then assessed and collected $7.7 million of LTD's corporate income tax deficiencies and additions to tax. In the U.S. District Court for the District of Columbia, LTD has commenced a refund action, InverWorld, Ltd. v. United States, Civil Action No. 93-1704-LFO (D.D.C., filed Mar. 11, 1994), which has been stayed pending resolution of the instant case. - 7 Tax Year Ended Deficiency Sec. 6651(a)(1) June 30, 1989 6,828,339 1,707,085 1 Additions to Tax Sec. Sec. 6653(a)(1) 6655 341,417 Sec. 6656 417,253 682,834 50 percent of the interest due on the deficiency. Respondent determined deficiencies in and additions to InverWorld, Inc.'s (INC) Federal withholding taxes as follows: InverWorld, Inc., Docket No. 3441-93 Additions to Tax Sec. Sec. 6653(a)(1)(A) 6653(a)(1)(B) Year Deficiency Sec. 6651(a)(1) 1987 $733,420 $183,355 Year Deficiency Sec. 6651(a)(1) Additions to Tax Sec. 6653(a)(1) Sec. 6656 1988 1989 1,524,928 2,951,566 381,232 737,891 76,246 --- 152,493 295,157 1 Sec. 6656 1 $36,671 $73,342 50 percent of the interest due on the deficiency. Respondent determined deficiencies in and additions to INC's Federal income tax for taxable years ended June 30, 1985 and 1986. Subsequent to the issuance of the statutory notice and upon submission of additional information to the District Director, Austin, respondent determined revised deficiencies in and additions to INC's Federal income tax as follows: InverWorld, Inc., Docket No. 27089-90 Tax Year Ended Deficiency Sec. 6653(a)(1) June 30, 1985 June 30, 1986 $77,851,228 157,044,730 $3,892,561 7,852,237 1 Additions to Tax Sec. 6653(a)(2) 1 1 50 percent of the interest due on the deficiency. Sec. 6661 $19,462,807 39,261,183 - 8 Respondent determined deficiencies in and additions to InverWorld Holdings, Inc.'s (Holdings) Federal income tax as follows: InverWorld Holdings, Inc., Docket No. 3442-93 Tax Year Ended Deficiency Sec. 6653(a)(1)(A) June 30, 1987 June 30, 1988 $454,333 365,507 $22,717 18,275 1 Additions to Tax Sec. 6653(a)(1)(B) 1 1 Sec. 6661 $113,471 91,377 50 percent of the interest due on the deficiency. Tax Year Ended June 30, 1989 Deficiency Sec. 6653(a)(1) Additions to Tax Sec. 6653(a)(2) Sec. 6661 1,453,333 72,667 --- 363,333 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. I. STATEMENT OF ISSUES The issues for decision are: A. Issues With Respect to LTD 1. Whether LTD is engaged in trade or business within the United States pursuant to section 864(b) for its taxable years ended June 30, 1985 through 1989;3 3 LTD’s deficiencies in income tax for its taxable years ended June 30, 1984, 1985, and 1986, are not at issue in the instant case. See supra note 2. We must, however, decide whether LTD was engaged in trade or business pursuant to sec. 864(b) for its taxable years ended June 30, 1985, and 1986, in order to apply the dividend source rules. See infra p. 174. - 9 2. if we decide that LTD is engaged in trade or business within the United States for its taxable years ended June 30, 1985 through 1989, then we must decide whether each item of LTD’s income was sourced from within or without the United States and whether each such item was effectively connected with the conduct of such trade or business within the United States;4 3. whether LTD is liable for branch profits tax pursuant to section 884 for its taxable years ended June 30, 1988 and 1989; 4. whether LTD is liable for environmental tax pursuant to section 59A for its taxable years ended June 30, 1988 and 1989; 5. whether LTD is liable for additions to corporate income tax pursuant to sections 6651, 6653(a), and 6656 for its taxable years ended June 30, 1987, 1988, and 1989; 6. whether LTD is liable as a withholding agent pursuant to sections 1441 and 1442 for failing to withhold tax on items of income of nonresident aliens and foreign corporations derived from sources within the United States for calendar years 1984 through 1989; 4 LTD’s deficiencies in income tax for its taxable years ended June 30, 1984, 1985, and 1986, are not at issue in the instant case. See supra note 2. We must, however, decide whether each item of LTD’s income was sourced from within or without the United States and whether each such item was effectively connected with the conduct of trade or business within the United States for its taxable years ended June 30, 1985 and 1986, in order to apply the dividend source rules. See infra p. 174. - 10 7. whether LTD is liable for additions to withholding tax pursuant to sections 6651, 6653(a), and 6656 for calendar years 1984 through 1989. B. Issues With Respect to INC 1. Whether income should be allocated to INC pursuant to section 482 for its taxable years ended June 30, 1985 and 1986; 2. whether INC is entitled to claimed deductions for legal and audit expenses for its taxable year ended June 30, 1986; 3. whether the net operating loss deduction claimed by INC should be increased for its taxable year ended June 30, 1985, and decreased for taxable year ended June 30, 1986; 4. whether investment credits claimed by INC should be increased for its taxable year ended June 30, 1985, and decreased for its taxable year ended June 30, 1986; 5. whether INC is liable for additions to corporate income tax pursuant to sections 6653(a) and 6661 for its taxable years ended June 30, 1985 and 1986; 6. whether INC is liable as a withholding agent pursuant to sections 1441 and 1442 for failing to withhold tax on items of income of nonresident aliens and foreign corporations derived from sources within the United States for calendar years 1987, 1988, and 1989; 7. whether INC is liable for additions to withholding tax pursuant to sections 6651, 6653(a), and 6656 for calendar years - 11 1987, 1988, and 1989. C. Issues With Respect to Holdings 1. Whether income should be allocated to Holdings pursuant to section 482 for its taxable years ended June 30, 1987, 1988, and 1989; 2. whether Holdings is entitled to claimed deductions for legal and audit fees for its taxable year ended June 30, 1987; 3. whether Holdings is entitled to claimed deductions for professional and legal fees for its taxable years ended June 30, 1988 and 1989; 4. whether Holdings is entitled to claimed deductions for employee training and recruiting for its taxable year ended June 30, 1989; 5. whether Holdings is liable for environmental tax pursuant to section 59A for its taxable year ended June 30, 1989; 6. whether Holdings is liable for additions to corporate income tax pursuant to sections 6653(a) and 6661 for its taxable years ended June 30, 1987, 1988, and 1989. II. FINDINGS OF FACT Some of the facts have been stipulated for trial pursuant to Rule 91. The parties’ stipulations of facts are incorporated herein by reference, and they are found accordingly. A. Petitioners LTD, an investment management and financial services - 12 company, is a corporation that was organized pursuant to the laws of the Cayman Islands on November 27, 1981. INC is a corporation that was organized pursuant to the laws of the State of Delaware on December 22, 1982. At the time the petitions in docket Nos. 27089-90 and 3441-93 were filed, INC's principal office was at 1250 N.E. Loop 410, Suite 1030, San Antonio, Texas 78209. During the years in issue, LTD owned, either directly or indirectly, all of the outstanding stock of INC. On November 15, 1985, INC was registered with the SEC as an investment adviser pursuant to section 203 of the Investment Advisers Act of 1940. Holdings is a corporation that was organized pursuant to the laws of the State of Delaware on February 24, 1987. At the time the petition in docket No. 3442-93 was filed, Holdings' principal office was at 1250 N.E. Loop 410, Suite 1030, San Antonio, Texas 78209. During certain of the taxable years in issue, LTD owned all the outstanding stock of Holdings, and Holdings was the owner of all of the outstanding stock of INC. B. Petitioners' Returns LTD maintained its books and records using a June 30 taxable year. LTD did not file U.S. Annual Withholding Tax Returns for U.S. Source Income of Foreign Persons (Forms 1042) for calendar years 1984, 1985, 1986, 1987, 1988, and 1989; U.S. Corporation Income Tax Returns of a Foreign Person (Forms 1120F) for its taxable years ended June 30, 1987, 1988, and 1989; or any other - 13 U.S. tax returns for calendar years 1984, 1985, 1986, 1987, 1988, and 1989, or its taxable years ended June 30, 1987, 1988, and 1989. During each of its taxable years ended June 30, 1984 through 1989, LTD did not file income tax returns with any governmental entity, either foreign or domestic. LTD did not file any statements, forms, or other documents in lieu of income tax returns in Mexico or the Cayman Islands. INC maintained its books and records using a June 30 taxable year. INC filed U.S. Corporation Income Tax Returns (Forms 1120) for taxable years ended June 30, 1985 and 1986. INC did not file U.S. Annual Withholding Tax Returns for U.S. Source Income of Foreign Persons (Forms 1042) for calendar years 1987, 1988, and 1989. For its taxable years ended June 30, 1987, 1988, and 1989, INC was joined in the consolidated income tax returns filed by Holdings. Holdings maintained its books and records using a June 30 taxable year. Holdings filed U.S. Corporation Income Tax Returns (Forms 1120) for taxable years ended June 30, 1987, 1988, and 1989. C. Creation of LTD LTD was created by principals of InverMexico, S.A. de C.V., Casa de Bolsa, which was a securities brokerage firm that was registered in Mexico and headquartered in Mexico City, Mexico. On November 27, 1981, LTD was incorporated as an exempted - 14 company5 pursuant to the laws of the Cayman Islands. To maintain its registration as an exempted company in the Cayman Islands, LTD submitted on March 4, 1983, November 21, 1983, December 5, 1984, February 18, 1988, November 29, 1988, and December 8, 1989, an "Annual Return and Declaration" stating, inter alia, that its operations since its last return have been mainly outside the Cayman Islands. LTD was a "sister company" of InverMexico; i.e., LTD and InverMexico were owned by the same persons or entities. During the years in issue, no client of LTD was a citizen or resident of the United States. The principals of InverMexico managed a diverse group of financial services companies in the name of InverMexico and other entities; such companies were called "Grupo Inver", or the "Inver Group". During the late 1970's and early 1980's, in the face of Mexico's declining oil revenues, the massive devaluation of the peso, and a growing sense of political instability, wealthy Mexicans increasingly sought opportunities outside Mexico's borders for investments that were considered safer than domestic investment opportunities. In response to such "capital flight", during those years the Mexican Government placed increasing 5 An "exempted company" is one the operation of which is conducted mainly outside the Cayman Islands. Secs. 179, 181, The Companies Law of the Cayman Islands. - 15 restrictions on the operations of Mexican financial institutions, having already closed its borders to non-Mexican financial institutions. The culmination of Mexico's restrictive investment regime was the imposition of exchange controls by presidential decree during September 1982 and the nationalization of the country's private banks. From that date onward, no Mexican- chartered bank or financial institution was permitted to handle foreign-currency-denominated accounts. lost value. Peso-based investments During 1982, many of the accounts managed by InverMexico were diminished as a result of the capital flight. Clients of InverMexico were sending their money to Merrill Lynch in the United States and to Swiss and Japanese banks. From its inception through its taxable year ended June 30, 1990, LTD did not file any registration statement, reporting statement, or any other statement with any governmental entity in Mexico. During each of its taxable years ended June 30, 1984 through 1990, LTD was not registered to do business in Mexico. D. Creation of INC Prior to 1983, LTD had fewer than 15 clients. For the administration of the accounts of such clients, LTD used the services of United States Trust Co. of New York (Cayman), Ltd. (United States Trust); Paine Webber; and Shearson, American Express, Inc. (Shearson). United States Trust provided basic research, accounting, bookkeeping, reporting, and order-filling - 16 services for LTD and maintained the account records of LTD's clients. United States Trust charged commissions directly against each individual account on a sliding scale with the highest charge being approximately 0.75 percent of a client’s net assets. For their equity investments, LTD clients used the investment management services of Paine Webber and Shearson. Generally, Shearson charged commissions directly against an LTD client’s account. Shearson then compensated either LTD or InverMexico by paying a percentage of the fees or commissions that Shearson earned from managing LTD clients' portfolios. After 1 year of working with United States Trust, LTD’s principals concluded that the service provided by United States Trust did not meet their expectations and that LTD was losing fee revenue and possibly clients to United States Trust. The executive committee of the Inver Group decided to create another related company that would perform the research, bookkeeping, and administrative services formerly provided by United States Trust. On December 22, 1982, INC was incorporated pursuant to the laws of the State of Delaware for that purpose. The original INC office was established in New York City by George Fahey, president and a director of INC. Mr. Fahey leased a small space at Rockefeller Center during early 1983. office personnel consisted of Mr. Fahey and a secretary. INC’s Mr. Fahey maintained that office through the end of calendar year - 17 1983. Notwithstanding the creation of INC, LTD's clients continued to keep their accounts at United States Trust through the end of 1983. Jose Zollino, treasurer and a director of INC, and Raymundo Leal, chairman of the board of directors of INC, moved to San Antonio, Texas, in August 1983. By November 1983, INC had leased space and opened an office in San Antonio. By the end of that year, Mr. Zollino informed Mr. Fahey that INC's management wanted to close the New York office and to have Mr. Fahey move to San Antonio. Mr. Fahey agreed to move to San Antonio, arriving there on January 15, 1984. Subsequently, LTD’s clients were transferred from United States Trust to LTD. Prior to that time, none of the United States Trust accounts had been transferred to LTD. For its office, INC purchased an office copier, computer equipment and software, and office equipment and furniture. E. Structure and Operation of LTD's Promotion, Service, and Sales As conceived by LTD's founders, LTD's business was to provide U.S. and foreign investment opportunities to InverMexico clients. As a foreign (i.e., non-Mexican) financial institution, however, LTD was restricted by Mexican law in the manner by which it could advise clients in Mexico. Accordingly, LTD chose not to establish a direct corporate presence in Mexico. When LTD was first established, its clients were on the client roster of InverMexico. Additionally, clients were referred to LTD by the principals of InverMexico (including principals of InverMexico - 18 who were directors, officers, or shareholders of LTD) and by InverMexico account executives and employees. Accordingly, LTD depended upon referrals rather than direct marketing. The account executives of InverMexico (known in Mexico as promotores and in the United States as promoters) were trained to sell in Mexico the services of the companies within the Inver Group, including LTD. For clients who were interested in Mexican, peso-based investments, an account would be opened at InverMexico. For clients who were interested in dollar deposits or other investments outside Mexico, an account would be opened at LTD. The number of client accounts at LTD was approximately 70 during 1984, 257 during 1985, 434 during 1986, 557 during 1987, 870 during 1988, and 1,131 during 1989. accounts were actively traded. Not all client For those years, the total amounts of client assets placed with LTD were $42,627,253 during 1984; $82,808,357 during 1985; $135,861,724 during 1986; $166,544,045 during 1987; $291,002,145 during 1988; and $285,621,179 during 1989. Each promoter earned compensation for services rendered in the form of a salary and bonus from InverMexico. Promoters also earned "commissions", which did not follow a strict formula in any one year. In some cases, a promoter might also have received a commission directly from LTD. Promoters presented new clients with a package of account opening documents, which consisted of signature cards, an - 19 Investment Management Agreement/Discretionary Authorization (discretionary authorization), the client’s investment instructions, and a power of attorney. The promoter explained the investment options available to the client and received the client's executed copies of the documents. It was the promoter's obligation to verify the facts presented in the account opening documents, including the fact that the client was not a resident or citizen of the United States Each signature card contained the client’s name and signature, the client’s LTD account number, and, generally, the client’s address. The discretionary authorization signed by each client granted LTD the "sole discretion" to invest the client’s assets in a vast range of financial products, subject to the client’s investment instructions, in consideration of a fee paid to LTD based on the net value of the client’s assets on the first day of each month. On a separate page for investment instructions, clients authorized division of their investments among four broad categories: assets, and other investments. Real estate, securities, fixed The discretionary authorizations specifically granted LTD the full power to delegate the whole or any part of its powers, duties, discretions and authority granted hereunder to InverWorld, Inc.[,] a wholly owned subsidiary of * * * [LTD], provided that * * * [LTD] shall remain fully liable to the Client for any and all actions of InverWorld, Inc.[,] undertaken pursuant to authority delegated to it by * * * [LTD]. - 20 The discretionary authorizations granted LTD the power to maintain or to transfer assets in omnibus accounts. In its early Discretionary Authorizations, as well as in a brochure for "selected investors who are not residents of the U.S.A.", and a printed newsletter entitled "InverNews", LTD listed the San Antonio office as its return address. Each client also granted a power of attorney to LTD, allowing LTD to make investments in the name of the client, to endorse for deposit and collection instruments payable to the client, and to pay bills and fees of third parties on behalf of the client. During LTD’s taxable years ended 1984 through 1986, inclusive, the powers of attorney were notarized in Bexar County, Texas. In some cases, the promoter assembled the account opening documents signed by the client and sent them to San Antonio, where they were countersigned in the name of LTD. Mr. Fahey executed "some" discretionary authorizations on behalf of LTD in the United States. Once the account was opened, the promoter directed the client to wire funds to a bank account opened in Texas in the name of LTD. LTD called this bank account the client clearing account or clearing account. Pursuant to its consulting agreement with LTD, INC had the authority to invest the "cash, securities, and other properties comprising the assets" of LTD's - 21 clients as instructed by LTD. During each of the years in issue, one or more employees or officers of INC had signatory authority for LTD’s bank accounts. INC maintained in San Antonio two types of files. The first type was the client statement file, or client file, which contained documents relating to client account activity. The client statement file contained copies of LTD Statements of Account, which identified only the client's LTD account number and, if applicable, the client's third party institution account number (e.g., the client's Shearson account number). Additionally, if applicable, the client statement files contained copies of: (1) Third party institution statements of account, which identified the client's name and the third party institution client number; (2) LTD Cash Receipt forms, which identified the client's name and LTD account number; (3) LTD Check Requisition forms, which identified the client's name and LTD account number; and (4) LTD Debit/Credit Memorandum forms, which identified the client's name and LTD account number. The second type of file maintained by INC in San Antonio was the client legal file, which contained documents relating to the establishment of the client account itself. file contained copies of: The client legal (1) The discretionary authorization between LTD and the client, which included the client's investment instructions and identified the client's name and LTD - 22 account number; (2) the power of attorney, which identified the client's name; (3) the client's Signature Card, signed by the client, which identified the client's name, LTD account number, and address; and (4) the client's passport, which identified the client's name. Additionally, if applicable, the client legal file contained correspondence, and, with corporate clients, corporate documents such as certificates of incorporation and minutes of corporate meetings. F. INC's Consulting Agreement With LTD LTD and INC entered into an agreement dated "as of February 1, 1983" (the Agreement). Pursuant to the terms of the Agreement, INC agreed to furnish LTD "with such factual information, research reports and investment recommendations relating to securities of issuers or other investments designated by * * * [LTD]". INC agreed to furnish LTD with "such advice as * * * [LTD] may reasonably request with respect to the relative attractiveness of securities of issues or other investments located in the United States." Paragraph 4 of the Agreement provides that, at the discretion of LTD, INC will invest such cash, securities and other properties comprising the assets of investment advisory clients of * * * [LTD] as * * * [LTD] shall instruct, in such manner as * * * [LTD] shall instruct. In order to carry out such instructions, * * * [INC] will have the authority for and in the name of * * * [LTD]: (a) to purchase, sell and deal in, on margin or - 23 otherwise, listed and unlisted capital stock, preorganization certificates and subscriptions, warrants, bonds, notes, debentures whether subordinated, convertible or otherwise, trust receipts, bankers’ acceptances, government obligations and other obligations, choses in action, instruments or evidences of indebtedness by whomsoever issued, and other securities of whatever kind or nature of any person, corporation, government or entity whatsoever, whether readily marketable or not, and such rights or options relating thereto including put and call options written by * * * [INC] on behalf of * * * [LTD] or by others (all such items being referred to herein as securities), and to sell such securities short and cover such sales; (b) to purchase, hold, sell, transfer, exchange, mortgage, pledge and otherwise act to acquire and dispose of and exercise all rights, powers, privileges, and other incidents of ownership or possession with respect to securities held on behalf of * * * [LTD] or its clients, with the objective of the preservation, protection and increase in value thereof; (c) to purchase securities for investment and to make such representations to the seller of such securities, and to other persons, that * * * [INC] may deem proper in such circumstances, including the representation that such securities are purchased by * * * [LTD] or its clients for investment and not with a view to their sale or other dispositions; (d) to lend any of the properties which are from time to time held by * * * [LTD] on behalf of its clients; and (e) to open, maintain, conduct and close accounts, including margin accounts, with any broker, dealer or investment concern at which * * * [LTD] maintains an account on behalf of its clients with respect to the disposition and application of monies or securities of * * * [LTD] or its clients and from time to time held by such broker, dealer or investment concern. Paragraph 5 of the Agreement provides that INC agrees to maintain all books and records relating to the accounting for transactions executed by * * * [INC] in accordance with paragraph 4. Such accounting services shall include, without limitation, the following: (a) maintaining documentation and records relating to the purchase, sale and settlement of portfolio securities, including an investment ledger and a dealer ledger; - 24 (b) monitoring, expediting and recording the collection of all income due * * * [LTD] or its clients; (c) summarizing, posting and recording all items of cash receipts and disbursements, including reconciling all bank accounts with the general books of account; (d) maintaining a general ledger for the recording of all transactions to the accounts of * * * [LTD] or its clients; and (e) preparing and issuing quarterly, semiannual and annual reports to * * * [LTD] and its clients and providing all information necessary for the preparation and filing of any and all tax returns and reports to governmental agencies by * * * [LTD] and its clients. Paragraph 6 of the Agreement provides: In consideration for the performance by * * * [INC] of the advisory and administrative Services pursuant to this Agreement, there shall be paid to * * * [INC] an annual fee of $114,000.00, payable monthly. The foregoing annual fee shall be subject to yearly amendment after review of the costs to * * * [INC] of providing services hereunder. Such costs shall include that portion of the salaries, wages and profit sharing of the employees of * * * [INC] attributable to the performance of services on behalf of * * * [INC] hereunder. Paragraph 8 of the Agreement provides: * * * [INC] shall for all purposes be an independent contractor and not an agent or employee of * * * [LTD], and * * * [INC] shall have no authority to act for, represent, bind or obligate * * * [LTD], any of its affiliates or any account managed or advised by * * * [LTD]. The Agreement was executed, on behalf of LTD, by William L. Bricker (a tax partner at Curtis, Mallet-Prevost, Colt & Mosle, in New York, New York, who was secretary and tax counsel of LTD) and, on behalf of INC, by Mr. Fahey. Letter agreements amended INC's annual fee pursuant to the Agreement for the taxable years ended June 30, 1984 through 1989. Such letter agreements were - 25 normally signed by Mr. Bricker on behalf of LTD and then sent to Mr. Fahey for his signature on behalf of INC. The letter agreement for the taxable year ended June 30, 1984, signed by Mr. Bricker and Mr. Fahey, was dated December 18, 1984. The letter agreement for the taxable year ended June 30, 1985, signed by Mr. Fahey but not Mr. Bricker, was dated July 1, 1984. The cover letter transmitting the letter agreement for the taxable year ended June 30, 1985, was dated July 17, 1985. LTD made 11 payments of $29,500, one each month, for a total of $324,500 in fees during taxable year ended June 30, 1985. LTD made an adjustment on June 30, 1985, paying an additional $257,500 in fees for a final total of $582,000 for taxable year ended June 30, 1985. The letter agreement for taxable year ended June 30, 1986, signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1, 1985". A letter from Steve Dooley, INC's controller, to Mr. Bricker requesting that INC's fee for taxable year ended June 30, 1986, be adjusted to $945,000 was dated July 18, 1986. The letter agreement for taxable year ended June 30, 1987, signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1, 1986". A letter dated August 5, 1987, telecopied from Mr. Dooley to Mr. Bricker included a suggested annual fee of $1,281,000 and a proposed profit and loss statement for INC's taxable year ended - 26 June 30, 1987. In his response letter dated August 17, 1987, Mr. Bricker asked Mr. Dooley "whether there may be some basis coming up perhaps with a similar result but basing it upon a percentage of assets." The letter agreement for taxable year ended June 30, 1988, signed by Mr. Bricker and Mr. Fahey, was dated "As of August 1, 1987". The letter agreement for taxable year ended June 30, 1989, signed by Mr. Bricker and Mr. Fahey, was dated "As of July 1, 1988". The total fees paid by LTD to INC and the gross revenues received by INC for each taxable year are set forth in the following table: TYE June 30 Management fee from LTD to INC Gross Revenues of INC Percentage of INC’s Gross Revenues 1985 1986 1987 1988 1989 $582,000 945,000 1,281,000 1,440,000 1,830,000 $618,190 953,583 1,395,545 1,532,579 1,909,563 94.1% 99.1 91.8 94.0 95.8 G. Research Pursuant to its Agreement with LTD, INC purchased, on behalf of clients of LTD, certificates of deposit and term deposits from banks located both within and without the United States. The executive committee of the Inver Group established criteria, relating to the bank’s size, equity, profitability, size of - 27 deposits, assets and liabilities ratios, and standing with the FDIC or FSLIC, to guide INC in selecting banks from which to purchase certificates of deposit and term deposits. Pursuant to its Agreement with LTD, INC assembled and maintained a document entitled Institution Standings, which reflected financial information regarding financial institutions. Mr. Fahey contacted a list of banks throughout the United States and obtained interest rates from each bank for 30-day, 60-day, 90-day, and 6-month placements of certificates of deposit and term deposits. A list of the rates quoted by each bank was telecopied, usually daily, to Mexico to inform promoters of the current interest rates offered on the certificates of deposit and term deposits. A promoter had no discretion to offer a client higher interest rates than the rates reflected on the list but did have the discretion to offer lower rates. H. Financial Accounting and Client Statements for LTD Pursuant to its Agreement with LTD, INC provided the bookkeeping for LTD. INC maintained all of LTD's records of clients' transactions, which LTD called "lower level documents". Such records consisted of cash receipts, debit-credit memos, wire transfers, and check requests reflecting every transaction for every client. During the years in issue, LTD’s lower level documents were maintained in the central filing system of INC in San Antonio. - 28 INC produced in San Antonio daily proof sheets, which summarized all client investment activities for a specified day. Proof sheets included a summary of client positions, a summary of the certificates of deposit activity, and a summary of the "casa" or house account. Proof sheets were based on individual documentation of specific transactions as well as comparisons of the specific transactional information to daily transaction reports. Proof sheets reflected, for example, that a certain dollar amount of client certificates of deposit had been bought on a particular day. During the years in issue, the proof sheets were maintained in INC's office in San Antonio although not in the central filing system. INC produced in San Antonio journal vouchers, which were summaries of the proof sheets, excluding references to client activity. Journal vouchers related only to the financial performance of LTD. INC used the journal vouchers to book income or credit and debit items to LTD. Additionally, INC used the journal vouchers to produce profit and loss statements and to make entries into different general ledger accounts. INC generated monthly statements of LTD client account activity. Each month, INC printed a client account statement summarizing the client's activity for the month and the client's holdings at a particular bank or investment fund. The client statements, which listed only the client’s LTD account number, - 29 were printed numerically by geographical region in Mexico. Generally, client statements were hand delivered by promoters to clients. The client statements either were picked up in San Antonio by a promoter from Mexico and taken to Mexico or were taken by someone from San Antonio to Mexico. After mid- 1988, INC transferred the information in the client statements onto a computer tape and transported the tape to Mexico City where the statements were printed and sent to the promoters for distribution to LTD’s clients. I. IRS Audit During Spring 1987 During the spring of 1987, the IRS notified INC that it would be the subject of an audit. After INC became aware of the upcoming audit, Mr. Dooley took LTD's general ledger to the Cayman Islands. Additionally, LTD's journal vouchers were sent to the Cayman Islands. The lower-level documents, however, remained in San Antonio. Mr. Dooley took the general ledger to the firm that LTD used to maintain its registration in the Cayman Islands and discussed the logistics of having the firm maintain the general ledger. Mr. Zollino decided, however, to begin maintaining LTD's general ledger in Mexico. Journal vouchers, which were used to make entries into LTD's general ledger, were still being produced in San Antonio. Accordingly, David Rodriguez, an INC employee, was sent to Mexico with the journal vouchers, which were entered - 30 into the laptop computer that he took with him from San Antonio to produce LTD's financial statements and general ledger. The data and general ledger system for both INC and LTD were needed in Mexico because Michael Graves, another INC employee, and Mr. Rodriguez were producing consolidated financial statements. While in Mexico, Mr. Graves was responsible for insuring the integrity of the general ledger system and its proper operation. When Mr. Graves and Mr. Rodriguez returned from Mexico to San Antonio, they brought with them the computer tape containing the client statements, the laptop computer containing the general ledgers for LTD and INC, and a floppy disk containing the general ledgers for INC and LTD. J. The Transition to MultiValores By the end of taxable year 1986, the Inver Group consisted of seven operating companies. During early 1986, the operations of InverMexico underwent a fundamental change, coinciding with its registration as a public company on the Mexican stock exchange. Such changes led to divisions within the Inver Group and a reexamination of LTD's relation to InverMexico. During January 1987, Luis Garcia Blake, the principal and owner of MultiValores S.A. de C.V. (MultiValores), a small, Mexican stock brokerage firm, proposed to Mr. Zollino that LTD join forces with MultiValores. The eight LTD partners who left InverMexico were joined in the new Inver Group by six principals - 31 of MultiValores who took interests in LTD. The combination with MultiValores in 1987 brought changes in the financial and operating controls of LTD and the Inver Group. Additionally, during 1988, promoters in Mexico began working with "district offices", which were consulting entities that served as intermediaries between LTD and LTD’s clients. K. Accounting Firm Audit LTD and INC engaged the services of the accounting firm of Deloitte Haskins & Sells (Deloitte) in 1984. For each taxable year ended June 30, 1984 through 1989, Deloitte performed a separate audit of each company and a consolidated audit of LTD and subsidiaries. L. LTD's Receipts LTD's receipts during the years in issue fall into four basic categories: (1) Management fees, (2) interest income, (3) currency transactions, and (4) sales commissions and fees. The total amounts of "gross receipts" and "direct costs" for each category are discussed below. 1. Management Fees LTD charged its clients for management of their assets in accordance with a "Schedule" or "Exhibit" attached to the discretionary authorization. By signing the power of attorney, each client authorized LTD to perform the following acts: (1) "To issue orders and directions to any bank or trust company for accounts held in name of the Client with respect to the - 32 maintenance, disposition and application of its monies, securities or commodities"; (2) "To open, maintain, conduct and close accounts in the Client's name with any broker, dealer or investment concern, to issue orders and directions to such broker, dealer or investment concern for its account with respect to the disposition and application of its monies, securities or commodities from time to time held by such broker, dealer or investment concern"; (3) "For the foregoing purpose to endorse for deposit and collection all checks, certificates of deposit, promissory notes, drafts, bills or exchange or other orders or instruments for the payment of money payable to its order"; and (4) "To pay bills and fees of third parties on behalf of the Client for goods or services which the Client has received or authorized." By signing the discretionary authorization, each client authorized LTD to "manage the investment of the cash, securities and other property of the Client as the Manager may hold from time to time." Each client agreed that LTD, in its sole discretion, shall invest the Assets in time deposits, money market funds or interest bearing investments or buy, sell (including short sales) and trade commodities, commodity options, stocks, bonds, options (including uncovered short positions in option contracts or in the uncovering of any existing short position in option contracts and any other securities and/or contracts relating to the same on margin or otherwise. The discretionary authorization set forth LTD's compensation system. The discretionary authorization stated: "The Client - 33 shall pay the Manager as full compensation for the services performed hereunder an annual fee based on the Manager's fee schedule in effect from time to time; and, agrees that such compensation may be deducted directly from the Assets by the Manager and paid when due." The fee was fixed at 0.25, 0.50 or 1.00 percent of the value of the client's net assets placed with LTD, depending upon the category of investment made by the client. During 1986, LTD began using a revised Discretionary Authorization in which LTD's fee was increased to 0.50 or 1.00 percent of the value of the client's net assets placed with LTD, depending upon the category of investment made by the client. The gross receipts and direct costs (viz, commissions to promoters) relating to LTD’s "Management Fees" for each taxable year are as follows: 2. TYE June 30 Gross Receipts Direct Costs 1985 1986 1987 1988 1989 $273,279 565,222 655,223 886,017 1,119,259 $33,852 88,112 51,978 27,620 (11,359) Interest Income a. U.S. Certificates of Deposit and Bank Deposits All investments made by or on behalf of LTD's clients were made in accordance with the terms of the discretionary authorization and power of attorney. With regard to any funds transferred to LTD's client clearing account for investment, the - 34 client agreed that the investment was entirely at the client's risk. The client agreed: (a) "to indemnify and hold * * * [LTD] harmless from and to pay * * * [LTD] promptly on demand any and all losses arising" from an investment; (b) that "* * * [LTD] shall not be liable for any error of judgment or for any loss suffered by the Client in connection with the subject matter of the * * * [investment management] Agreement"; (c) that to the extent LTD acted as attorney in fact for the client, it was for the client's "account and risk"; and (d) that to the extent the client placed funds in excess of FDIC or FSLIC insurance at any one bank (through LTD or otherwise) "the client's investments may not be fully covered by such insurance." LTD was also authorized by each client to pool that client’s funds with other clients’ funds in order to obtain higher rates of return. In authorizing LTD to pool funds, a client agreed that "* * * [LTD] shall have the power to maintain, commingle, or transfer Assets in omnibus accounts in the name of * * * [LTD] as attorney in fact for the client and other clients having an interest in the omnibus account." During 1986, the discretionary authorization signed by each client was changed to include the provision that - 35 The rate of return credited to the Client's account may not reflect directly the rate of return earned by specific investments; the Client's rate of return may be net of expenses or may reflect the fact that * * * [LTD] may retain the benefit of special rates attributable to the volume of investments controlled by * * * [LTD]. For any amounts transferred by the client in excess of $100,000, a certificate of deposit was purchased in the client's own name in the face amount of $98,000. The maximum amount that could be protected pursuant to the U.S. Government insurance programs of the FDIC and FSLIC was $100,000. For amounts less than $100,000 and in increments of $10,000, a client's funds were pooled with the funds of one or more other LTD clients to purchase another $98,000 certificate of deposit. LTD called such a pooled fund the "IFF Fund". LTD represented to its clients that IFF was a 28-day investment in a portfolio comprising money market instruments and that IFF was created only once a week. IFF, however, was merely a marketing name used to differentiate between pooled and nonpooled purchases of certificates of deposit. each client’s investments. INC performed a daily accounting of If a client had more than $10,000 in liquid funds in an LTD account as of the day once a week on which LTD "created" the IFF Fund, INC placed the client’s funds in the IFF Fund in $10,000 increments. By having the funds pooled, a higher rate of return was earned on larger certificates of deposit. IFF paid interest at a rate 20 basis points over the rate reported in the Wall Street - 36 Journal's 30-day Jumbo CD report. Because the funds were pooled, LTD purchased the certificate of deposit in its own name pursuant to its authority to act as attorney in fact for each client in an omnibus account. Initially, when the interest was remitted to the client clearing account, a credit would be entered on each client's account. Later, LTD changed its policy to credit each client's account monthly, even though LTD had yet to receive any interest income. Finally, for amounts less than $10,000, and in increments of $100, a client’s funds were left on deposit in LTD’s client clearing account, and the client’s account was credited with the average rate paid by Frost Bank on the average balances for any particular period. Account" (MMA). LTD called such account the "Money Market LTD represented MMA to its clients as demand deposits in a portfolio comprising money market instruments. MMA, however, was merely a marketing name for the investment mechanism that we have described supra. INC performed a daily accounting of each client’s investments. If a client had funds of less than $10,000 in an LTD account, INC placed the client’s funds into the MMA in $100 increments. Any funds of a client below $100 were not so invested. LTD derived three types of income from using the funds in the client clearing account to invest in U.S. certificates of deposit and U.S. bank deposits. The first type of income earned - 37 by LTD was called a "byte",6 which was the difference between the interest obtained on client certificates of deposit and the interest credited to client accounts. The second type of income earned by LTD was called internally "basis" income. For certain certificates of deposit purchased in the client’s name, LTD paid clients a rate of return based upon a 365-day term of maturity when such certificates actually had a 360-day term of maturity. LTD retained the difference, which it called "basis" income. The third type of income earned by LTD was the "spread", which was either the difference between (1) the interest obtained on certificates of deposit purchased in LTD’s name and the interest credited to client accounts for their IFF investments or (2) the interest obtained on LTD's client clearing account and the interest credited to client accounts for their MMA investments. Through the end of 1985, LTD credited its clients on the entire amount of interest earned on IFF. During LTD’s taxable year ended June 30, 1985, the date on which clients were paid interest for investments in certificates of deposit was the date on which the interest was received by LTD. With respect to the IFF and MMA, the date of payment of interest was independent of the date interest was received by LTD from the banks. 6 The record reveals that the term "byte" was used also to refer to what we call LTD’s "spread". - 38 b. Loans During March 1986, LTD began making loans to clients. The loans were collateralized by the clients' own certificates of deposit. LTD verified the availability of funds and then transferred the funds to the borrowers, usually by wire. LTD lent the money to the client at the prime rate plus a maximum amount of 2 percent. Accounting loans that were used to finance purchases in other funds, however, were charged the interest rate that the collateral was carrying, with the result that LTD did not receive any income. Loans made to clients were not reflected on the books of LTD but were recorded against a particular client's account. In documents for a loan to its clients, LTD listed the San Antonio office as its return address. c. Non-U.S. Certificates of Deposit and Term Deposits During its taxable year ended 1989, LTD began offering its clients the opportunity to place their funds in pooled investments outside the United States. Such non-U.S. certificates of deposit and non-U.S. term deposits program used the same mechanics for investment as the pooled purchases of U.S. certificates of deposit. LTD pooled clients’ funds and either purchased non-U.S. certificates of deposit or made non-U.S. term deposits in its own name, as attorney in fact, in accordance with the clients' authorization provided to LTD in the discretionary authorizations. Accordingly, the client, not LTD, bore the risk - 39 of a bank failure or other loss of the investment. Because there was no Government-sponsored insurance on the non-U.S. investments, there was no purpose in dividing the purchases into amounts of $100,000 or under. Consequently, all of the non-U.S. investments were in amounts of $1 million or more, which paid higher rates of return. LTD offered its clients investments in non-U.S. certificates of deposit through products named "Eurodeposits", "InverCedes", and "InverCede2". LTD offered its clients investments in non- U.S. term deposits through products named "Liquid Assets" and "Term Deposits". LTD offered its clients a non-U.S. investment named "Asset Management Account". The names denoted different methods of timing of interest paid to the client, availability of funds, deposit amounts, etc. Each such certificate of deposit or term deposits, however, constituted a purchase from an omnibus account in bank deposits outside the United States and Mexico. INC collected quotations of rates on certificates of deposit and term deposits from various banks and telecopied to the promoters term sheets listing all of the quoted rates. The term sheets listed the top rate paid by each bank, and promoters selling such investments negotiated a rate of return with clients. Promoters could negotiate a lower, but not higher, rate than the one listed on the term sheets. To the extent that a bank might quote a higher rate of return because of the size of the pooled deposit or the volume of transactions, LTD was - 40 permitted by the discretionary authorization to retain a portion of the enhanced return as its income. d. Pace Investments LTD offered Pace investments (including one called Pace II) to clients who had unused lines of credit with Mexican financial institutions. Generally, such institutions would have insufficient liquidity to allow clients to draw any further funds on their lines of credit. LTD offered to its clients (who were not necessarily the ones with unused lines of credit with Mexican financial institutions) a stated rate of return on funds invested for a fixed period of time. LTD deposited such funds with banks in Mexico for a period of time coinciding with the maturity date agreed upon with LTD's clients. deposited funds. LTD earned interest on the The deposit was made with the stipulation that the money be used to allow LTD’s client in Mexico to draw on its formerly unused line of credit. The client, now able to draw upon its line of credit, paid LTD a fee to complete the transaction. LTD derived income on the difference between (1) the sum of the interest earned from the Mexican bank and the fee earned from the client and (2) the interest paid to its clients as their stated rate of return for making a deposit with LTD. e. MMA II MMA II was a "back-to-back" operation designed to take advantage of a loophole in the Mexican tax law that lasted - 41 approximately 18 months before it was closed. In a basic back- to-back operation, a client’s funds deposited with LTD were used as collateral for loans to a related client account. More specifically, the mechanism took the following form: a client, usually a Mexican corporation, placed U.S. dollars in LTD's MMA II fund. The money was then lent to the owner of the client corporation (MMA II notes). The dollars were exchanged by the owner of the client corporation into pesos, and the pesos were used to buy Mexican Treasury bills or "cetes", which were lent to the client corporation. The Treasury bills were sold by the client corporation and exchanged into dollars, and the dollars were deposited into the client corporation's MMA II fund with LTD. LTD charged its client corporations 1 percent more for the loan than the interest rate paid on the MMA II notes. One of LTD’s "Direct Costs" of its interest income is an item entitled "Interest Expense - Special Accounts". Such expense represents the amount that LTD paid to LTD accounts such as, inter alia,7 FEIM Fund, Currency Fund, and TVA, for their positions in, inter alia, Eurodeposits, IFF, Pace Investments, and InverCedes. The gross receipts and direct costs relating to LTD’s "Interest Income" for each taxable year are as follows: 7 We note that LTD had more investment products and investment funds during the taxable years in issue than the parties have addressed. - 42 TYE June 30 Gross Receipts Direct Costs 1985 1986 1987 1988 1989 $751,058 1,431,377 2,313,288 2,900,805 11,771,193 $574,076 953,362 1,870,419 1 2,053,624 8,112,563 1 We have deducted from the amount of direct costs the amount of $4,521, which represents LTD's T-bill commission expense for taxable year ended June 30, 1988, and which has been recategorized in "Commissions - T-Bills." Accordingly, we recalculate the direct costs for LTD's taxable year ended June 30, 1988, to be $2,053,624. The breakdown of LTD’s "Direct Costs" for each taxable year is as follows:8 TYE June 30 1985 1986 1987 1988 1989 Direct Cost IFF + MMA IFF MMA IFF MMA Commissions Byte Casa interest IFF MMA Byte IFF MMA Asset Management Account Eurodeposits InverCedes Liquid Assets Term Deposits Special Accounts Amount 1 $574,076 545,781 407,581 472,938 475,268 726 887,634 33,853 690,978 949,087 413,559 874,404 1,473,299 1,107 576,089 880,845 191,344 4,626 259,414 8 The parties stipulated total amounts that constitute direct costs relating to LTD’s "Interest Income" category. The parties, however, did not stipulate a breakdown of the direct costs, which is necessary to our analysis, infra pp. 101-108, relating to LTD’s interest income. We note that facts disclosed by the Deloitte workpapers and the IRS revenue agent’s workpapers provide the breakdown of the direct costs, which we set forth herein and utilize in our analysis, infra pp. 101-108. - 43 Pace MMA II Byte 831,176 2,903,946 116,313 1 The record indicates that, in the direct costs for taxable year ended June 30, 1985, the interest expenses consisted of IFF and MMA interest expenses combined without distinction. 3. Currency Exchange Transactions Income LTD engaged in two types of currency exchange transactions. a. Currency Swaps LTD arranged for its clients currency swaps, which were contracts in dollar futures. In a currency swap, LTD and a client entered into a contract in which LTD agreed to sell U.S. dollars to the client for Mexican pesos at some future date. The sale price for the dollars was determined in accordance with the interest rate negotiated between LTD and the client. LTD's gross receipts consisted of commissions that it received from Bank of America and United States Trust for arranging the currency swaps. LTD’s direct costs were the commissions it paid out for arranging the currency swaps. LTD stopped arranging currency swaps on September 1, 1984. The gross receipts and direct costs relating to LTD’s "Commissions on Foreign Exchange" are as follows: TYE June 30 Gross Receipts Direct Costs 1985 $54,386 $24,750 b. Currency Transactions The second category of currency exchange transactions that LTD engaged in was the sale and purchase of dollars on behalf of - 44 clients. i. LTD engaged in four types of dollar transactions. LTD arranged sales of dollars to a client in exchange for pesos. The client contacted a promoter in Mexico, who quoted an exchange rate for pesos to dollars. Once the client and the promoter agreed on a rate, the promoter performed the exchange operation from his office in Mexico. The client made pesos available in Mexico to be exchanged, and the promoter documented receipt of the pesos. The promoter then converted the pesos to dollars at a Government-authorized Mexican exchange house. Once the exchange was executed, the promoter directed that the dollars be wired to San Antonio to be credited to the client's account. The transaction appeared as a credit on the client's monthly statement. LTD's income derived from the difference between the exchange rate obtained from the Mexican exchange house and the rate quoted to and agreed to by the client. ii. LTD sold dollars from its own account to a client in exchange for pesos. LTD transferred money, usually by wire, from its Frost Bank Money Market account to the client's designated financial institution. The transaction appeared as a debit from LTD's Frost Bank account. iii. LTD arranged purchases of dollars from a client in exchange for pesos. The client withdrew dollars from an LTD account to exchange with pesos obtained by LTD. The transaction appeared as a debit on the client's monthly statement. - 45 iv. LTD purchased dollars from a client in exchange for pesos and deposited the dollars into LTD's own account. The transaction appeared as a credit to LTD's Frost Bank account. Only transaction (i) involved the performance of personal services in Mexico by a promoter. Specifically, in transaction (i), the promoter handled the exchange with the Mexican brokerage house. In transactions (ii), (iii), and (iv), the currency transactions were handled in San Antonio with pesos being deposited with or received from Mexican institutions. As of its taxable year ended June 30, 1989, LTD ceased to conduct the currency transactions in its own name. The gross receipts and direct costs relating to LTD’s income from "Currency Transactions" for each taxable year are as follows: TYE June 30 1985 1986 1987 1988 1 Gross Receipts 1 $531,003 745,001 2 434,867 3 232,426 Direct Costs - 0 130,485 16,125 16,863 The amount of gross receipts actually represents a net balance amount with expenses already deducted. Neither revenue agent's workpapers nor Deloitte's workpapers reveal the true gross amount. 2 The amount of gross receipts includes a check of $11,361 from the Guadalajara office representing its contribution to profits. 3 The amount of gross receipts includes a check of $16,426 from the Guadalajara office representing its contribution to profits. - 46 4. Sales Commissions and Fees a. Currency Fund LTD created the "InverWorld Currency Fund" (Currency Fund) to offer its clients access to the international currency market. Clients purchased units in the Currency Fund in $1,000 increments with a $20,000 minimum. LTD deposited the funds in a foreign bank, which decided in which currencies the funds that LTD placed with it would be invested. The client's yield on the fund was based on any increase in the value per share over the term of the investment. No periodic dividend or interest was paid. LTD's role was to act as "Manager" of the Currency Fund. LTD and INC received clients’ funds, transferred them for management by the European banks, and issued a periodic statement of the client's allocated share of the Fund, using values determined by the fund managers in Europe. Funds that were "placed" by LTD’s clients in the Currency Fund were not always placed by LTD in foreign institutions. During the taxable year ended June 30, 1988, funds in the Currency Fund were invested in cash accounts, money market accounts, and investment accounts managed by Merrill Lynch and Lombard Odier & Lir (Lombard). During the taxable year ended June 30, 1989, funds in the Currency Fund were invested in Euro-deposits, Pace investments, loans, and investment accounts managed by Bear Stearns, Merrill Lynch, and Lombard. - 47 LTD charged its clients an initial placement cost of 3 percent of the funds placed in the Currency Fund. After the first year LTD also charged an annual management fee of 1.00 percent of the value of the assets under management. The gross receipts and direct costs relating to LTD’s "Commissions Currency Fund" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1986 1987 1988 1989 $116,604 264,395 61,510 (6,509) $35,293 34,480 1,858 - 0 - b. FEIM Fund The FEIM (an acronym for Fondo Estragegico De Inversion Multiple) Fund was available to LTD clients during taxable years ended June 30, 1986 through 1989. Similar in operation to the Currency Fund, the FEIM Fund initially consisted of a basket of GNMA, FNMA, and Federal Home Loan Mortgage Association mortgages. During taxable year ended June 30, 1988, client funds were invested in the IFF. During taxable year ended June 30, 1989, client funds were invested in money market accounts, Eurodeposits, Pace investments, loans, and investments managed by Bear Stearns, Morgan Stanley, and Shearson. FEIM authorizations directly to INC. Clients sent signed However, during the first 2 years, neither LTD nor INC had any role in the investment, management, or valuation of the FEIM Fund assets. LTD marketed the investment through its promoters in Mexico, and INC's only - 48 role was to arrange for transfer of the client funds to Merrill Lynch in Luxembourg and to include a monthly statement of the client's allocated share of the fund value. Such valuation was performed by the fund's managers at Merrill Lynch. 1988, LTD had stopped sending funds overseas. By June 30, In one of its brochures describing the FEIM Fund, LTD listed the San Antonio office as its return address. LTD charged its clients an initial placement cost based on a sliding scale of 4.00 percent to 0.25 percent, depending upon the amount of funds placed in the FEIM Fund. After the first year LTD also charged an annual management fee of 1.00 percent of the value of the assets under management. The gross receipts and direct costs relating to LTD’s "Commissions - FEIM Fund" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1986 1987 1988 1989 $148,354 71,716 (3,000) 4,951 $44,500 11,587 116 - 0 - c. Matric Fund The Matric Fund (Matric) was an investment fund financing a time-share resort in Puerto Vallarta, Mexico. Matric Corp., organized in the Cayman Islands, borrowed $10 million from LTD, with Vallarta Internacional S.A., a Mexican corporation, as its guarantor. LTD raised the $10 million by seeking commitments from its clients to invest in Matric. - 49 Clients investing in Matric signed an agency agreement with LTD. Pursuant to the agency agreement, clients agreed to indemnify LTD for any potential loss and to hold LTD responsible for paying clients their share of the interest payments remitted by Matric only if Matric paid LTD. LTD earned three types of income in connection with Matric during the tax year ending June 30, 1989. The first type of income that LTD earned was a 3-percent commission on the $10 million note, prorated for the 9 months that the note was outstanding during taxable year ended June 30, 1989. The second type of income that LTD earned was an initiation fee of 3-percent of the $10 million note. The last type of income that LTD earned was a consulting fee of $47,500. The gross receipts and direct costs relating to LTD’s "Commissions [Matric]" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1989 $575,000 - 0 - d. Inversat Fund LTD created Inversat REIT, a U.S. real estate investment trust (REIT), to market to its clients. Clients purchased shares in the REIT by placing funds with LTD, which in turn placed them in its Inversat Fund. LTD then allocated the funds from the Inversat Fund to the Inversat REIT, which purchased and managed U.S. real estate. The Fund consisted of 5,000 shares, sold at $1,000 each, with a minimum investment of $20,000. LTD sold all - 50 2,774 shares in taxable year ended June 30, 1987. In one of its brochures describing the Inversat Fund, LTD listed the San Antonio office as its return address. LTD charged its clients an initial placement cost based on a sliding scale of 3.50 to 0.25 percent, depending upon the amount of funds placed in the Inversat Fund. After the first year LTD also charged an annual management fee of 1.00 percent of the value of the assets under management. The gross receipts and direct costs relating to LTD’s "Commissions Inversat" for each taxable year are as follows (it is noted that the Inversat Fund management fee was not charged until taxable year ended June 30, 1988, and is reported under the general "Management Fees" category): TYE June 30 Gross Receipts Direct Costs 1987 $86,762 $3,188 e. T.V. Answer T.V. Answer (TVA) is an attachment for television sets that uses radio signals to communicate with a minicomputer system. With the attachment, consumers can use their televisions to order movies, to purchase goods, to retrieve information, to respond to polls, and the like. TVA, Inc., was formed to exploit the commercial potential of TVA. TVA, Inc., a Delaware corporation, was the wholly owned subsidiary of Magus, Ltd., a Cayman Islands corporation, which was in turn wholly owned by a trust. - 51 On July 7, 1986, in Monterrey, Mexico, LTD, entered into a contract with the inventors of TVA and the investors in TVA, Inc. (TVA partners). LTD agreed to obtain the funds necessary for the commercial exploitation of TVA. To that end, LTD formulated a prospectus and executed a marketing program to solicit venture capital. The capital call was directed by Arnulfo Rodriguez, head of MultiValores' investment banking unit in Monterrey. All potential subscribers were contacted from the Monterrey office. Essentially, LTD raised $4,400,000 by purchasing units in the trust for its clients' accounts. For its expenses incurred in the capital call, LTD directed INC to send Magus, Ltd., an invoice approximately every 6 months. LTD also instructed INC to pay TVA monthly an amount to cover its development expenses. INC performed no other activities in the capital call. In raising the funds for TVA, LTD received three types of income. The first type of income was, pursuant to its contract with the TVA partners, LTD’s right to commissions of 5 percent of the total funds that it raised for TVA. The second type of income was an administration fee from the TVA partners at a rate of $5,000 per month. The third type of income was revenue that LTD received by charging some clients who purchased units in the trust a percentage commission. The gross receipts and direct costs relating to LTD’s "Commissions TV Answer" and "TV Answer * * * [Administration] Fee" for each taxable year are as follows: - 52 TYE June 30 Commissions Administration Fee Direct Costs $15,000 60,000 60,000 $166,829 800 - 0 - 1 1987 1988 1989 $210,675 50,607 272,411 We have deducted from the amount of commissions, $225,675, the amount of $15,000, which represents LTD's administration fees and which has been recategorized under "Administration Fee" for taxable year ended June 30, 1987. 1 f. Client Incorporation and Trust Creation LTD offered its clients the option of establishing offshore corporations and trusts to hold their investments. Each client signed a discretionary authorization granting LTD the power to invest the funds held by the client’s corporation or trust. To establish an offshore corporation or trust for a client, a promoter in Mexico completed a form listing the client’s choice of jurisdiction, company name, and appointed directors. Such form was then sent to INC, which passed the information to outside lawyers or fiduciaries qualified to perform the necessary paperwork in the chosen jurisdiction. The incorporation package completed by the lawyers or fiduciaries was then returned to INC, which returned the package to the client in Mexico. LTD's role, through the promoters, was to provide the counseling on the structure and features of the various incorporation options. Board of directors meetings for at least two companies incorporated by LTD clients were held at INC’s offices in San Antonio. LTD's clients used as their addresses the address of INC’s offices in San Antonio. - 53 Clients establishing an offshore corporation or trust were charged fees for the service directly against their accounts. LTD’s gross receipts derived from charging an "opening expense" and an "annual expense". LTD’s direct costs were its payments to the third party lawyers and fiduciaries. The gross receipts and direct costs relating to LTD’s "Client Incorporation Fees" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1986 1987 1988 1989 $147,951 363,014 290,518 404,286 $18,286 126,855 161,037 227,697 g. Legal Advice Income In an operating manual under the heading, "Legal Advise" (sic) LTD described its services regarding the creation of offshore corporations and trusts. The record reveals only that LTD derived gross receipts relating to "Legal Advice Income". LTD’s direct costs were the commissions that it paid to promoters for counseling clients regarding offshore corporations or trusts. The gross receipts and direct costs relating to LTD’s "Legal Advice Income" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1988 1989 $8,630 (328) $3,453 5,272 h. Letters of Credit LTD issued, either directly or through a bank, letters of credit to Mexican banks to secure loans for its clients. The - 54 letters of credit were collateralized by certificates of deposit that LTD had purchased with the client's funds. The gross receipts and direct costs relating to LTD’s "Income from Letters of Credit" for each taxable year are as follows: TYE June 30 Gross Receipts Direct Costs 1 1987 1988 1989 $24,152 91,556 53,047 - 0 - 0 - 0 - 1 We have recategorized under "Income from Letters of Credit" for taxable year ended June 30, 1987, the amount of $24,152 of gross receipts, which was originally categorized under "Other Income". i. Foreign Exchange Investments LTD derived income from its foreign exchange investments. The gross receipts and direct costs relating to LTD’s "Income Foreign Exchange Invest" are as follows: TYE June 30 Gross Receipts Direct Costs 1987 $8,425 - 0 - j. Treasury Bills LTD earned commissions from third parties on the sale of U.S. Treasury bills to LTD’s clients. For taxable year ended June 30, 1989, LTD’s commissions were from Merrill Lynch. LTD’s direct costs were the commissions that it paid to promoters. The gross receipts and direct costs relating to LTD’s "Commissions T-bills" for each taxable year are as follows: - 55 TYE June 30 Gross Receipts Direct Costs 1 1988 1989 2 $15,139 5,026 $4,521 - 0 - 1 We have recategorized under "Commissions - T-bills" for taxable year ended June 30, 1988, the amount of $15,139 of gross receipts, which was originally categorized under "Other Commission Income". 2 We have recategorized under "Commissions - T-bills" for taxable year ended June 30, 1988, the amount of $4,521 of direct costs, which was originally categorized under "Interest Income". k. Wires and Checks LTD charged its clients fees for transactions with third party banks. For example, when a wire was sent or a foreign check was received for deposit, the third party bank sometimes charged a transaction fee to LTD, which passed through the fee to the client, plus a transaction fee of its own. type of transaction, LTD added a $10 to $15 fee. Depending on the The gross receipts and direct costs relating to LTD’s "Wire and Check Fees" for each taxable year are as follows: TYE June 30 1987 1988 1989 Gross Receipts 1 $6,866 13,274 26,360 Direct Costs - 0 - 0 - 0 - 1 We have recategorized under "Wire and Check Fees" for taxable year ended June 30, 1987, the amount of $6,866 of gross receipts, which was originally categorized under "Other Income". l. Gold and Silver Futures LTD maintained a gold and silver futures operations for its clients. The gross receipts and direct costs relating to LTD’s - 56 "Gold/Silver Income" for each taxable year are as follows: TYE June 30 Gross Receipts 1988 1989 $14,110 60,112 m. Direct Costs $371 - 0 - Project Income LTD earned income on a research project for one of LTD's clients. The gross receipts and direct costs relating to LTD’s "Project Income" are as follows: TYE June 30 Gross Receipts 1988 $20,000 n. Direct Costs $4,135 Income From Investments In the investment income category, LTD earned four items of revenue. LTD reported gain on the sale of Currency Fund units. The funding account (also known as the client clearing account) purchased Currency Fund units from clients during October and November and subsequently sold them to the Currency Fund account for a gain of $64,291.18. Additionally, LTD reported the gain on the sale of FEIM Fund units. The funding account purchased FEIM Fund units from clients and subsequently sold them to the FEIM Fund account for a gain of $44,576.33. LTD had a loss on the sale of stock in a concern known as TAMSA in the amount of $11,275.35. Finally, LTD had a loss on an investment in Mexican stocks in the amount of $83,061.23. The gross receipts and direct costs relating to LTD’s "Income from Investments" are as - 57 follows: TYE June 30 Gross Receipts 1988 $14,531 o. Direct Costs - 0 - Other Commission Income/ Other Commissions and Fees For taxable year ended June 30, 1988, the category "Other Commission Income" included two types of revenue: $1,640 as commissions on a "back-to-back" transaction and $776 as commissions on the sale of stock. For taxable year ended June 30, 1989, the category "Other Commissions and Fees" included two types of revenue: $24,633 as additional commission fees that were charged to clients considered to be of higher than normal risk, and $8,852 as commissions on the sale of Inver stock. The gross receipts and direct costs relating to LTD’s "Other Commission Income" and "Other Commissions and Fees" for each taxable year are as follows: TYE June 30 1988 1989 Gross Receipts 1 $2,416 33,485 Direct Costs - 0 - ("Other Commission Income") 8,345 ("Other Commissions and Fees") 1 We have deducted from the amount of gross receipts, $17,555, the amount of $15,139, which represents LTD's commissions from sales of Treasury bills and which has been recategorized under "Commissions on the Sale of Treasury Bills" for taxable year ended June 30, 1988. p. Other Income For taxable year ended June 30, 1985, the income items taken as samples for Deloitte’s audit constituted "interest payments". - 58 For taxable year ended June 30, 1986, the Deloitte workpapers provide no indication regarding the specific income items taken as audit samples. For taxable year ended June 30, 1987, audit samples included: (1) $24,152 for Letters of Credit, which has been recategorized to "Letters of Credit", (2) $22,443 for Other Income, (3) $6,866 for Wire and Check Fees, which has been recategorized to "Wire and Check Fees", and (4) $2500 for Commissions and Fees. For taxable year ended June 30, 1988, the four items taken as samples for Deloitte's audit were: (1) Interest earned on the sale of TVA, Inc. stock when the customer committed to buy the stock but did not pay for it for several months, (2) commissions on the sale of Lombard positions, (3) gain from the sale of Arabian horses, and (4) fees from guaranteeing a line of credit for a client. For taxable year ended June 30, 1989, the three items taken as samples for Deloitte's audit were: (1) A reversal of excess interest paid to a client in a prior year, (2) a reversal of interest paid to a customer in error (with the end result of canceling out the item initially listed as an interest expense), and (3) revenue received for assisting a client in taking a special tax election. The gross receipts and direct costs relating to LTD’s "Other Income" for each taxable year are as follows: - 59 TYE June 30 Gross Receipts Direct Costs 1985 1986 1987 1988 1989 $49,297 20,735 1 24,943 83,442 108,250 - 0 - 0 - 0 - 0 96,692 1 We have deducted from the amount of gross receipts, $55,961, the amount of $24,152, which represents LTD's letters of credit fees, and which has been recategorized under "Fees for Letters of Credit" for taxable year ended June 30, 1987. Additionally, we have deducted from the amount of gross receipts the amount of $6,866, which represents LTD's wire and check fees, and which has been recategorized under "Wire and Check Fees" for taxable year ended June 30, 1987. M. Amounts Subject to Withholding Tax The total amounts in docket No. 27090-90 on which LTD is potentially liable for withholding tax for each calendar year are as follows:9 $481,692 for 1984; $1,168,498 for 1985; and $1,135,757 for 1986. The breakdown of these amounts for each calendar year is as follows: Calendar Year 1984 Type of Interest or Dividend IFF Amount $333,137 9 For calendar years 1984, 1985, and 1986, the parties stipulated as revisions to the statutory notice of liability amounts in docket No. 27090-90 on which LTD is potentially liable for withholding tax. The parties, however, did not stipulate a breakdown of the withholding amounts, which is necessary to our analysis, infra pp. 160-184, relating to LTD’s withholding tax liability. We note that a stipulated joint exhibit provides the breakdown of the withholding amounts, which we set forth herein and utilize in our analysis, infra pp. 160-184. We note that the stipulated joint exhibit provides total amounts subject to withholding tax different from the total amounts stipulated by the parties. - 60 1985 1986 MMA IFF MMA Dividend IFF MMA Dividend 148,540 460,160 205,186 503,147 593,093 529,512 13,146 LTD declared a dividend of $516,263 on December 10, 1985, and payable on December 20, 1985, to LTD shareholders according to an established schedule. LTD paid $503,147 in calendar year 1985 and $13,146 in calendar year 1986. Both dividend payments, however, were made during LTD’s taxable year ended June 30, 1986. The total amounts in docket No. 3443-93 on which LTD is potentially liable for withholding tax for each calendar year are as follows:10 $1,668,636 for 1987;11 $6,105,862 for 1988; and 10 For calendar years 1987, 1988, and 1989, the parties stipulated as revisions to the statutory notice of liability amounts in docket No. 3443-93 on which LTD is potentially liable for withholding tax. The parties, however, did not stipulate a breakdown of the withholding amounts, which is necessary to our analysis, infra pp. 160-184, relating to LTD’s withholding tax liability. We note that a stipulated joint exhibit provides the breakdown of the withholding amounts, which we set forth herein and utilize in our analysis, infra pp. 160-184. We note that the stipulated joint exhibit provides total amounts subject to withholding tax different from the total amounts stipulated by the parties. 11 The statutory notice of liability included a dividend in the amount of $500,000 that was subject to withholding tax for calendar year 1987. The parties’ stipulated joint exhibit, however, did not include any dividend amount as subject to withholding tax for calendar year 1987. At the commencement of trial, respondent moved to amend the answers and to conform the pleadings to the proof in docket nos. 3441-93 and 3443-93. Respondent’s motions included an attempt to introduce the $500,000 dividend as an amount subject to (continued...) - 61 $10,867,511 for 1989. The breakdown of these amounts is as follows: Calendar Year Type of Interest or Dividend Amount 1987 IFF MMA Byte IFF MMA InverCedes MMA II Byte IFF MMA Asset Management Account Eurodeposits InverCedes InverCede2 Liquid Assets $400,129 587,014 681,493 1,115,904 1,751,904 220,178 3,017,875 257,872 402,695 800,214 12,222 1,579,147 1,434,760 92,305 379,880 1988 1989 11 (...continued) withholding tax for calendar year 1987. Respondent contended that, because the dividend was in the statutory notice of liability for calendar year 1987, it was still in issue. Petitioners objected to the dividend issue on the ground that it was raised "only on the eve of trial." The Court denied the motions as untimely. Respondent argues on brief that "the Court did not specifically rule on petitioners’ objection" and that their objection "should be overruled." We believe that implicit in our denial of the motions to amend and to conform the pleadings to the proof was a ruling that petitioners’ objection was sustained. Consequently, we find that the $500,000 dividend is not an amount that is in issue for calendar year 1987 in the instant cases. For calendar year 1988, the parties’ stipulated joint exhibit listed in brackets a dividend in the amount of $500,000 but did not include such amount in the total amount that was subject to withholding tax. A dividend in the amount of $500,000 was not included in the statutory notice of liability for calendar year 1988. Consequently, we find that the $500,000 amount listed as a dividend in the stipulated joint exhibit is not an amount that is in issue for calendar year 1988 in the instant cases. - 62 Special Accounts Term Deposits Pace Byte 259,411 10,018 5,895,859 33,822 Respondent seeks to levy an identical withholding tax on INC for calendar years 1987, 1988, and 1989. We find that the total amounts on which INC is potentially subject to withholding tax are the same as for LTD, viz, $1,668,636 for 1987; $6,105,862 for 1988; and $10,867,511 for 1989. The breakdown of the withholding amounts is also the same as for LTD. III. A. See supra. OPINION Whether LTD Was Engaged in Trade or Business Within the United States The first issue we must decide is whether LTD was engaged in trade or business within the United States pursuant to section 864(b). If we decide that LTD was engaged in trade or business within the United States, then we must decide the character and the source of each item of LTD's income and whether each such item was effectively connected with the conduct of such trade or business pursuant to section 864(c). Foreign corporations operating in the United States are subject to two U.S. taxation regimes. Under the first regime, a foreign corporation engaged in trade or business within the United States during the taxable year is taxable on its income which is effectively connected with the conduct of such trade or business within the United States (effectively connected income). - 63 Sec. 882(a)(1). Effectively connected income can originate from sources within the United States, sec. 864(c)(2) and (3), or from sources without the United States, sec. 864(c)(4), and is taxed at the same rates that apply to a U.S. corporation under section 11. Under the second regime, a flat tax of 30 percent is imposed on a foreign corporation’s gross income from "interest (other than original issue discount as defined in section 1273), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income", but only to the extent the amount is received from sources within the United States and is not effectively connected with the conduct of trade or business by such corporation within the United States. Sec. 881(a). A foreign corporation is not subject to tax on its income which is not effectively connected with its conduct of trade or business within the United States and which is received from sources without the United States. Id. In sum, if LTD is engaged in trade or business within the United States, income items effectively connected with LTD's trade or business, including items from sources without the United States as described in section 864(c)(4), are taxed pursuant to section 882(a)(1) at regular corporate rates; income items not effectively connected with any trade or business conducted by LTD within the United States, if sourced from within - 64 the United States, are taxed at 30 percent pursuant to section 881(a), but if sourced from without the United States, are not subject to U.S. taxation. 1. Background For purposes of section 882(a)(1), the phrase "trade or business within the United States" generally includes "the performance of personal services within the United States at any time within the taxable year". Sec. 864(b). We believe that section 1.864-4(c)(5)(i), Income Tax Regs., which determines whether a foreign corporation is "engaged in the active conduct of a banking, financing, or similar business in the United States", provides a useful framework in the instant case for analyzing whether LTD engaged in trade or business within the United States. For, if LTD engaged in the active conduct of a banking, financing, or similar business in the United States, then, a fortiori, LTD was engaged in trade or business within the United States. 2. Section 1.864-4(c)(5)(i), Income Tax Regs., Engaged in a Banking Business Test Section 1.864-4(c)(5)(i), Income Tax Regs., provides that a foreign corporation is considered to be engaged in the active conduct of a banking, financing, or similar business in the United States if at some time during the taxable year the taxpayer is engaged in business in the United States and the activities of such business consist of any one or more of the following activities carried on, in whole or in - 65 part, in the United States in transactions with persons situated within or without the United States: (a) Receiving deposits of funds from the public, (b) Making personal, mortgage, industrial, or other loans to the public, (c) Purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness, (d) Issuing letters of credit to the public and negotiating drafts drawn thereunder (e) Providing trust services for the public, or (f) Financing foreign exchange transactions for the public. LTD engaged in four of the six activities listed in the regulation. LTD engaged in "Receiving deposits of funds from the public" by receiving deposits of funds from its clients into its client clearing account. LTD engaged in "Making personal * * * loans to the public" by making loans to its clients. LTD engaged in "Purchasing * * * [and] selling * * * for the public on a regular basis * * * evidences of indebtedness" by purchasing and selling for its clients on a regular basis: (1) Certificates of deposit and (2) interests in such certificates of deposit. engaged in "Issuing letters of credit to the public". LTD Finally, LTD engaged in "Financing foreign exchange transactions for the public" by effecting currency exchange transactions for the public with Mexican banks. LTD engaged in all of the above activities,12 in whole or in part, in the United States in 12 Additionally, LTD engaged in creating and operating a U.S. (continued...) - 66 transactions with persons situated within or without the United States. Accordingly, we conclude that LTD performed the activities required for a foreign corporation to be considered "a banking, financing, or similar business in the United States" within the meaning of section 1.864-4(c)(5)(i), Income Tax Regs. In addition to the listed activities, however, section 1.864-4(c)(5)(i), Income Tax Regs., requires that the foreign corporation "at some time during the taxable year" be "engaged in business in the United States". Petitioners argue that certain trading activities performed by LTD are excludable from the determination of whether LTD is engaged in "trade or business within the United States" pursuant to section 864(b). Petitioners argue that pursuant to section 864(b)(2)(A)(i) and (ii), LTD’s trading in stocks or securities are excluded from the determination of whether LTD is engaged in "trade or business within the United States". The activity of "Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent" is excluded from the definition of "trade or business within the United States". 864(b)(2)(A)(i). Sec. The exclusion applies, however, "only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by 12 (...continued) real estate investment trust, creating offshore corporations and trusts, purchasing U.S. Treasury bills, and trading in gold and silver futures. - 67 the direction of which the transactions in stocks or securities * * * are effected." Sec. 864(b)(2)(C). Petitioners argue that all of their activities are eligible to be excluded because the exclusion extends broadly to persons trading for their own account or for the account of others and because the agents through which trading is effected need not be independent in order to qualify under section 864(b)(2)(A)(i). We disagree. The exclusion requires that the trading in stocks or securities be effected "through a resident broker, commission agent, custodian, or other independent agent." 864(b)(2)(A)(i). Sec. We conclude that the phrase means that excludable trading in stocks or securities must be effected through independent agents and that LTD's trading through INC was not so effected. To qualify for the exclusion, trading in stocks or securities must be effected by the agents referred to in section 864(b)(2)(A)(i). The fourth relationship to which that section refers is an "other independent agent." We believe that the phrase "other independent agent" serves to modify the language preceding it. In other words, the resident broker, commission agent, or custodian must each be an "independent agent." Consequently, we conclude that section 864(b)(2)(A)(i) requires that the trading in stocks or securities be effected through an independent resident broker, an independent commission agent, an - 68 independent custodian, or some other independent agent. The record shows that LTD engaged in the trading of securities through a resident broker by virtue of its certificates of deposit operation.13 The Inver Group established criteria to guide INC in selecting the financial institutions from which INC could purchase certificates of deposit for LTD and LTD’s clients. INC researched the financial institutions using the Inver Group’s criteria and obtained interest rate quotes. Upon receipt of funds and an order to invest, INC placed the funds in certificates of deposit in either the client’s or LTD’s name. We conclude that, by engaging in such activities, LTD engaged in trading in securities through its agent INC. Section 1.864-7, Income Tax Regs., provides a definition of "independent agent" for purposes of determining whether a foreign corporation has "an office or other fixed place of business within the United States" within the meaning of section 864(c)(4)(B) and the regulations thereunder. The phrase "office or other fixed place of business in the United States" also appears in section 864(b)(2)(C). Although the regulation does not expressly provide that it is to apply for purposes of section 13 Sec. 1.864-2(c)(2)(i), Income Tax Regs., defines a security for purposes of par. (c) of sec. 1.864-2, Income Tax Regs., as: "any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing." - 69 864(b)(2)(A)(i), we believe that the regulation furnishes a proper framework for interpreting the term "independent agent" for purposes of section 864(b)(2)(A)(i). Section 1.864-7(d)(3)(i), Income Tax Regs., provides: For purposes of this paragraph * * * [of the regulation], the term “independent agent” means a general commission agent, broker, or other agent of an independent status acting in the ordinary course of his business in that capacity. Thus, for example, an agent who, in pursuance of his usual trade or business, and for compensation, sells goods or merchandise consigned or entrusted to his possession, management, and control for that purpose by or for the owner of such goods or merchandise is an independent agent. Section 1.864-7(d)(3)(ii), Income Tax Regs., however, provides: The determination of whether an agent is an independent agent for purposes of this paragraph shall be made without regard to facts indicating that either the agent or the principal owns or controls directly or indirectly the other or that a third person or persons own or control directly or indirectly both. For example, a wholly owned domestic subsidiary corporation of a foreign corporation which acts as an agent for the foreign parent corporation may be treated as acting in the capacity of independent agent for the foreign parent corporation. The facts and circumstances of a specific case shall determine whether the agent, while acting for his principal, is acting in pursuance of his usual trade or business and in such manner as to constitute him an independent agent in his relations with the nonresident alien individual or foreign corporation. Finally, section 1.864-7(d)(3)(iii), Income Tax Regs., provides: Where an agent who is otherwise an independent agent within the meaning of subdivision (i) of this subparagraph acts in such capacity exclusively, or almost exclusively, for one principal who is a nonresident alien individual or a foreign corporation, the facts and circumstances of a particular case shall be taken into account in determining whether the agent, while acting in that capacity, may be classified as an independent agent. - 70 Applying the foregoing regulations to the facts of the instant case, we note that, although INC was, either directly or indirectly, a wholly owned subsidiary of LTD, section 1.8647(d)(3)(ii), Income Tax Regs., requires the determination of whether INC is an independent agent to be made without regard to the fact that LTD "owns or controls directly or indirectly" INC. Accordingly, we disregard the fact that LTD owned, either directly or indirectly, all of INC in our consideration of whether INC was "a general commission agent, broker, or other agent of an independent status acting in the ordinary course of * * * [its] business in that capacity." Sec. 1.864-7(d)(3)(i), Income Tax Regs. INC was an investment adviser registered with the SEC. INC’s business, in part, was that of a broker of certificates of deposit. Guided by Inver Group’s criteria, INC researched and selected the financial institutions from which it purchased certificates of deposit for LTD and LTD’s clients. brokerage services for LTD and LTD’s clients. INC performed INC, however, acted almost exclusively for one principal, i.e., LTD, which is a foreign corporation. Consequently, we conclude that INC is an "exclusive" agent within the meaning of section 1.8647(d)(3)(iii), Income Tax Regs., supra. Accordingly, we must take into account the facts and circumstances "in determining whether the agent, while acting in that capacity, may be classified as an independent agent." Sec. 1.864-7(d)(3)(iii), Income Tax Regs. - 71 The record shows that INC had few clients other than LTD and LTD’s clients. The services that INC performed were almost exclusively for LTD, such as bookkeeping, effecting trades in securities, generating client statements, and effecting currency exchange transactions. The percentage of INC’s gross revenues derived from LTD were as follows: 94.1 percent in 1985, 99.1 percent in 1986, 91.8 percent in 1987, 94.0 percent in 1988, and 95.8 percent in 1989. Moreover, the record does not establish that INC marketed its services to clients on its own. Based on the record in the instant case, we conclude that INC was not an "independent agent" within the meaning of section 1.864-7(d)(3), Income Tax Regs. Consequently, we hold that LTD did not engage in trading in stocks or securities through an independent agent within the meaning of section 864(b)(2)(A)(i). Additionally, section 864(b)(2)(A)(i) applies "only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities * * * are effected." Sec. 864(b)(2)(C); see sec. 1.864-2(c)(1), Income Tax Regs. Both parties, presuming that INC's San Antonio office was an office through which or by the direction of which LTD’s transactions in stocks or securities were effected, focus their arguments on whether INC's San Antonio office can be attributed to LTD. Petitioners seek to apply - 72 section 1.864-7(d)(1)(i), Income Tax Regs.14 Accordingly, petitioners contend that INC's office in San Antonio should not be considered LTD's "office or other fixed place of business" in the United States because INC did not have the authority to negotiate or to conclude contracts on behalf of LTD. Petitioners argue that, "Even if INC is deemed to be a dependent agent, by its agreement with LTD it had 'no authority to act for, represent, bind or obligate * * * [LTD]' without first obtaining LTD’s consent and in fact it did not do so without first obtaining the consent of LTD." Respondent also seeks to apply section 1.864-7(d)(1)(i), Income Tax Regs., contending that INC's San Antonio office should be considered LTD's office for the purpose of applying the regulation. Section 1.864-7(d)(1)(i), Income Tax Regs., provides that the office of an agent who is not an independent agent will be disregarded in the determination of whether a taxpayer has "an 14 Sec. 1.864-7(d)(1)(i), Income Tax Regs., provides: In determining whether a nonresident alien individual or a foreign corporation has an office or other fixed place of business, the office or other fixed place of business of an agent who is not an independent agent, as defined in subparagraph (3) of this paragraph, shall be disregarded unless such agent (a) has the authority to negotiate and conclude contracts in the name of the nonresident alien individual or foreign corporation, and regularly exercises that authority, or (b) has a stock of merchandise belonging to the nonresident alien individual or foreign corporation from which orders are regularly * * * [filled] on behalf of such alien individual or foreign corporation * * *. - 73 office or other fixed place of business in the United States" unless the agent performs specified duties. The physical location of the office of an agent, however, is only one factor of five provided in section 1.864-7, Income Tax Regs., to be considered in such a determination. Section 1.864-7(d)(1)(i), Income Tax Regs., expressly provides that it applies for purposes of section 864(c)(4)(B) and section 864(c)(4)(B)(iii), and the regulations thereunder, but it does not expressly provide that it is to apply for purposes of section 864(b)(2)(C). Nonetheless, because both parties argue their respective positions based on section 1.864-7(d)(1)(i), Income Tax Regs., and because those regulations construe the phrase "office or other fixed place of business in the United States", which is also found in section 864(b)(2)(C), we use those regulations in the instant case as a framework to decide whether LTD has "an office or other fixed place of business in the United States" for purposes of section 864(b)(2)(C). Section 1.864-7(a)(2), Income Tax Regs., provides that, in determining whether a taxpayer has "an office or other fixed place of business in the United States" within the meaning of the statute, "due regard shall be given to the facts and circumstances of each case, particularly to the nature of the taxpayer's trade or business and the physical facilities actually required by the taxpayer in the ordinary course of the conduct of his trade or business." The factors to consider include: (1) - 74 Fixed facilities, (2) management activity, (3) agent activity, (4) employee activity, and (5) office or other fixed place of business of a related person. Sec. 1.864-7, Income Tax Regs. We examine each of the factors in turn. (1) Fixed facilities. The general rule is that "an office or other fixed place of business is a fixed facility, that is, a place, site, structure, or other similar facility, through which a nonresident alien individual or a foreign corporation engages in a trade or business." Sec. 1.864-7(b)(1), Income Tax Regs. "A fixed facility may be considered an office or other fixed place of business whether or not the facility is continuously used by a nonresident alien individual or foreign corporation." Id. Furthermore: A nonresident alien individual or a foreign corporation shall not be considered to have an office or other fixed place of business merely because such alien individual or foreign corporation uses another person’s office or other fixed place of business, whether or not the office or other fixed place of business of a related person, through which to transact a trade or business, if the trade or business activities of the alien individual or foreign corporation in that office or other fixed place of business are relatively sporadic or infrequent, taking into account the overall needs and conduct of that trade or business. * * * [Sec. 1.864-7(b)(2), Income Tax Regs.] (2) Management activity. The regulations take into account where the "top management" decision-making takes place and where "the day-to-day trade or business of the foreign corporation” occurs. (3) Sec. 1.864-7(c), Income Tax Regs. Agent activity. The regulations provide: - 75 the office or other fixed place of business of an agent who is not an independent agent, as defined in subparagraph (3) of this paragraph, shall be disregarded unless such agent (a) has the authority to negotiate and conclude contracts in the name of the nonresident alien individual or foreign corporation, and regularly exercises that authority, or (b) has a stock of merchandise belonging to the nonresident alien individual or foreign corporation from which orders are regularly * * * [filled] on behalf of such alien individual or foreign corporation. * * * [Sec. 1.8647(d)(1)(i), Income Tax Regs.] The regulations also provide: an agent shall be considered regularly to exercise authority to negotiate and conclude contracts or regularly to fill orders on behalf of his foreign principal only if the authority is exercised, or the orders are filled, with some frequency over a continuous period of time. This determination shall be made on the basis of the facts and circumstances in each case, taking into account the nature of the business of the principal; but, in all cases, the frequency and continuity tests are to be applied conjunctively. Regularity shall not be evidenced by occasional or incidental activity. An agent shall not be considered regularly to negotiate and conclude contracts on behalf of its foreign principal if the agent’s authority to negotiate and conclude contracts is limited only to unusual cases or such authority must be separately secured by the agent from his principal with respect to each transaction effected. * * * [Sec. 1.864-7(d)(1)(ii), Income Tax Regs.] (4) Employee activity. The regulations provide: Ordinarily, an employee of a nonresident alien individual or a foreign corporation shall be treated as a dependent agent to whom the rules of paragraph (d)(1) of this section apply if such employer does not in and of itself have a fixed facility (as defined by paragraph (b) of this section) in the United States or outside the United States, as the case may be. However, where the employee, in the ordinary course of his duties, carries on the trade or business of his employer in or through a fixed facility of such employer which is regularly used by the employee in the course of carrying out such duties, such fixed facility shall be considered the office or other fixed place of - 76 business of the employer, irrespective of the rules of paragraph (d)(1) of this section. * * * [Sec. 1.8647(e), Income Tax Regs.] (5) person. Office or other fixed place of business of a related The regulations provide: The fact that a nonresident alien individual or a foreign corporation is related in some manner to another person who has an office or other fixed place of business shall not of itself mean that such office or other fixed place of business of the other person is the office or other fixed place of business of the nonresident alien individual or foreign corporation. Thus, for example, the U.S. office of foreign corporation M, a wholly owned subsidiary corporation of foreign corporation N, shall not be considered the office or other fixed place of business of N unless the facts and circumstances show that N is engaged in trade or business in the United States through that office or other fixed place of business. However, see paragraph (b)(2) of this section * * * [regarding relatively sporadic or infrequent activities]. * * * [Sec. 1.8647(f), Income Tax Regs.] With the foregoing factors in mind, we consider the facts and circumstances of the instant case. The record establishes that LTD had a fixed facility in the sense that it used the San Antonio office to engage in its trade or business. The San Antonio office, upon receipt of investment instructions from the promoters, effected the transactions in question. The San Antonio office’s address was used as LTD’s return address on, inter alia, LTD’s early discretionary authorizations, a FEIM Fund brochure, an Inversat Fund brochure, a brochure for "selected investors who are not residents of the U.S.A.", a printed newsletter entitled "InverNews", and in documents for a loan to a - 77 client. The San Antonio office was the place where LTD client files were maintained. LTD's use of the San Antonio office for both its operations and as a return address was so extensive that we believe, taking into account the overall needs and conduct of LTD’s trade or business, that LTD’s use of the San Antonio office cannot be described as falling under the "relatively sporadic or infrequent" exception. Sec. 1.864-7(b)(2), Income Tax Regs. Moreover, LTD has not shown that it maintained any other fixed facility through which it engaged in its activities. Accordingly, we hold that the San Antonio office was LTD’s fixed facility in the United States during the years in issue for purposes of section 1.864-7(b), Income Tax Regs. As to the location of the management activity, section 1.864-7(c), Income Tax Regs., and related examples, section 1.864-7(g), Examples (1)-(3), Income Tax Regs., take into account not only where the "top management decisions" are made but also where "the day-to-day trade or business of the foreign corporation" is conducted. LTD’s day-to-day trade or business was to provide its Mexican clients with access to non-Mexican financial markets. That day-to-day trade or business was conducted in the San Antonio office, where the clients’ files were located, investment instructions were received and carried out, client statements were produced, and LTD’s daily proof sheets and journal vouchers were produced. - 78 As we have concluded, supra p. 70, that INC is not an "independent agent" within the meaning of section 1.864-7(d)(3), Income Tax Regs., we next examine whether INC is a dependent agent15 which "has the authority to negotiate and conclude contracts in the name of the nonresident alien individual or foreign corporation, and regularly exercises that authority" within the meaning of section 1.864-7(d)(1)(i), Income Tax Regs. Petitioners argue that, if INC is deemed to be a dependent agent, INC is not to be considered regularly to "negotiate and conclude contracts" on behalf of LTD because INC had, pursuant to its agreement with LTD, no authority to act for, represent, bind or obligate LTD "without first obtaining LTD’s consent" and that INC did not act for, represent, bind, or obligate LTD "without first obtaining the consent of LTD." Additionally, petitioners contend that INC did not have the authority to negotiate or to conclude contracts on LTD’s behalf. In deciding whether INC had that type of authority, we examine the agreement governing the relationship between INC and LTD (Agreement) and the entire record before us. Petitioners rely upon paragraph 8 of the Agreement, which provides that INC "shall for all purposes be an independent contractor and not an agent or employee of * * * [LTD], and * * * [INC] shall have no 15 A dependent agent is equated in the regulations with "an agent who is not an independent agent, as defined in subparagraph (3) of this paragraph". Sec. 1.864-7(d)(1)(i), Income Tax Regs. - 79 authority to act for, represent, bind or obligate * * * [LTD], any of its affiliates or any account managed or advised by * * * [LTD]." Paragraph 4 of the Agreement, however, provides detailed authority for INC to act on LTD’s behalf: * * * [INC] will invest such cash, securities and other properties comprising the assets of investment advisory clients of * * * * [LTD] as * * * [LTD] shall instruct, in such manner as * * * [LTD] shall instruct. In order to carry out such instructions, * * * [INC] will have the authority for and in the name of * * * [LTD]: (a) to purchase, sell and deal in * * * instruments or evidences of indebtedness by whomsoever issued * * *; (b) to purchase, hold, sell, transfer, exchange, mortgage, pledge and otherwise act to acquire and dispose of and exercise all rights, powers, privileges, and other incidents of ownership or possession with respect to securities held on behalf of * * * [LTD] or its clients, with the objective of the preservation, protection and increase in value thereof; (c) to purchase securities for investment and to make such representations to the seller of such securities, and to other persons, that * * * [INC] may deem proper in such circumstances, including the representation that such securities [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A28c62cd3ca3e9e93. Public record. Not legal advice.