UNITED STATES TAX COURT
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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 are purchased by * * * [LTD] or its clients for
investment and not with a view to their sale or other
disposition;
(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 * * *
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.
Thus, paragraph 8 and paragraph 4 contain seemingly inconsistent
terms.
As we interpret the Agreement, however, the specific vesting
of authority in INC upon the issuance of instructions from LTD,
pursuant to paragraph 4 of the Agreement, overrides the provision
- 80 in paragraph 8 that INC "shall have no authority to act for,
represent, bind or obligate" LTD as to the matters covered by the
instructions.
We therefore conclude that INC had “the authority
for and in the name of LTD” to carry out the acts specified in
the Agreement pursuant to LTD’s instructions, including, inter
alia, purchasing, selling, and dealing in instruments or
evidences of indebtedness by whomsoever issued.
INC alone
performed the purchase, sale, and redemption of the instruments
and evidences of indebtedness.
Accordingly, we conclude that,
pursuant to its Agreement with LTD, INC had "the authority to
negotiate and conclude contracts" in the name of the foreign
corporation LTD within the meaning of section 1.864-7(d)(1)(i),
Income Tax Regs.
Nonetheless, we must consider whether INC "regularly
exercised" its authority to negotiate and to conclude contracts
in LTD’s name, whether such authority was limited to unusual
cases, and whether such authority was separately secured for each
transaction effected within the meaning of section 1.8647(d)(1)(ii), Income Tax Regs.
For LTD’s certificates of deposit
and term deposits operation, the executive committee of Inver
Group established criteria (relating to the bank’s size, equity,
profitability, size of 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
- 81 deposits.
Mr. Fahey testified that he compiled a list of banks
that Mr. Zollino approved.
Pursuant to its Agreement with LTD, INC assembled and
maintained a document entitled Institution Standings, which
reflected the financial information of financial institutions
that met the Inver Group’s criteria.
Mr. Fahey contacted banks
throughout the United States that were on the approved list and
obtained interest rates from each bank for 30-day, 60-day, 90day, 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 certificates of deposit and
term deposits.
Mr. Fahey testified that he "got approval of the
banks that were on * * * [the list telecopied to promoters], but
not approval on a daily basis for the rates that I quoted on
there."
Promoters sold the certificates of deposit or term
deposits (or interests therein) to clients, who wired funds
directly to LTD’s account in San Antonio.
On its own, albeit pursuant to the criteria established by
Inver Group and only from banks that had been approved by Mr.
Zollino, INC purchased certificates of deposit or term deposits
in either the client’s name (for amounts greater than $98,000) or
in LTD’s name (for amounts less than $98,000, in increments of
$10,000).
INC purchased the certificates of deposit and term
deposits on behalf of LTD and LTD’s clients with great frequency
- 82 over the continuous period of time in issue.
INC’s authority to
purchase certificates of deposit and term deposits was not
"limited only to unusual cases", and its authority was not
"separately secured" by INC from LTD "with respect to each
transaction effected."
The exercise of INC’s authority was not
merely occasional or infrequent.
Accordingly, we conclude that
INC exercised its authority to negotiate and to conclude
contracts with the regularity and continuity required by section
1.864-7(d)(i)(ii), Income Tax Regs.
Consequently, we hold that
INC is a dependent agent who had "the authority to negotiate and
conclude contracts" in the name of the foreign corporation LTD
and "regularly" exercised such authority within the meaning of
section 1.864-7(d)(1)(i), Income Tax Regs.
As INC is a dependent agent which had "the authority to
negotiate and conclude contracts" in the name of LTD and
"regularly" exercised such authority over a continuous period of
time, INC’s office will not be disregarded in determining whether
LTD had an office or other fixed place of business within the
meaning of section 1.864-7(d), Income Tax Regs.
7(d)(3)(i), Income Tax Regs.
Sec. 1.864-
Accordingly, we conclude that INC’s
office is to be used in deciding whether LTD had "an office or
other fixed place of business in the United States" within the
meaning of section 1.864-7(d), Income Tax Regs.
As INC is a corporation, and respondent makes no argument
that its separate existence should be ignored, and as LTD had no
- 83 employees of its own in the San Antonio office, we do not apply
the factor of employee activity.
Sec. 1.864-7(e), Income Tax
Regs.
Finally, section 1.864-7(f), Income Tax Regs., provides that
the fact that a foreign corporation is related in some manner to
another person who has an office or other fixed place of business
will not of itself mean that the related person’s office or other
fixed place of business is the foreign corporation’s office or
other fixed place of business unless the facts and circumstances
show that the foreign corporation is engaged in trade or business
in the United States through such office or fixed place of
business.
Based on the record in the instant case, we conclude
that the facts and circumstances show that LTD was engaged in
trade or business in the United States through INC’s office in
San Antonio.
As we have discussed, supra pp. 72-73, LTD's
involvement and activities in the San Antonio office were
extensive, continuous, and regular.
Moreover, LTD has not shown
that it maintained any other office or fixed place of business.
Accordingly, we conclude that the San Antonio office of INC is
the office or other fixed place of business of LTD for purposes
of section 1.864-7(f), Income Tax Regs.
Pursuant to section 1.864-7(a)(2), Income Tax Regs., we have
given "due regard" to the facts and circumstances of the instant
case, "particularly to the nature of the taxpayer's trade or
business and the physical facilities actually required by the
- 84 taxpayer in the ordinary course of the conduct of his trade or
business."
The nature of LTD’s trade or business is to provide
Mexican investors with access to non-Mexican financial markets.
The physical facility actually required by LTD in the ordinary
course of the conduct of its trade or business is a place that
can receive investment instructions from clients, effect such
instructions, and maintain records of actions that have been
taken.
LTD had no place that received clients’ investment
instructions, effected such instructions, and maintained records
of actions taken, other than the San Antonio office.
In sum, we
conclude that LTD had "an office or other fixed place of business
in the United States" within the meaning of section 1.864-7(d),
Income Tax Regs.
Consequently, we hold that LTD’s trading in stocks or
securities fails to qualify for exclusion pursuant to section
864(b)(2)(A)(i) for each of two reasons:
(1) The trading in
stocks or securities was not carried out through an "independent"
agent, and (2) LTD had "an office or other fixed place of
business in the United States" through which such transactions
were effected.
See sec. 864(b)(2)(C).
Accordingly, such trading
activities are taken into account to determine whether LTD was
engaged in "trade or business within the United States" pursuant
to section 864(b).
We turn next to the exclusion allowed to taxpayers trading
for their own account.
Section 864(b)(2)(A)(ii) provides that
- 85 certain activities are to be excluded from the definition of
"trade or business within the United States," to wit:
Trading in stocks or securities for the taxpayer's own
account, whether by the taxpayer or his employees or
through a resident broker, commission agent, custodian,
or other agent, and whether or not any such employee or
agent has discretionary authority to make decisions in
effecting the transactions. * * *
Trading in stocks or securities, equated in the regulations with
"the effecting of transactions in the United States in stocks or
securities," includes:
buying, selling (whether or not by entering into short
sales), or trading in stocks, securities, or contracts
or options to buy or sell stocks or securities, on
margin or otherwise, for the account and risk of the
taxpayer, and any other activity closely related
thereto (such as obtaining credit for the purpose of
effectuating such buying, selling, or trading). * * *
[Sec. 1.864-2(c)(2)(i), Income Tax Regs.]
The exclusion for trading in stocks or securities for the
taxpayer's own account, however, does not apply to:
(1) A dealer
in stock or securities, and (2) a corporation (other than one
described in the parenthetical clause of section
864(b)(2)(A)(ii)) whose principal business is trading in stocks
or securities for its own account and whose principal office is
in the United States.
Sec. 864(b)(2)(A)(ii).
A dealer in stocks
or securities is defined as "a merchant of stocks or securities,
with an established place of business, regularly engaged as a
merchant in purchasing stocks or securities and selling them to
customers with a view to the gains and profits that may be
derived therefrom."
Sec. 1.864-2(c)(2)(iv)(a), Income Tax Regs.
- 86 In the determination of whether a person is a dealer in stocks or
securities, "such person's transactions in stocks or securities
effected both in and outside the United States shall be taken
into account."
Id.
The term "securities" for purposes of
paragraph (c) of section 1.864-2, Income Tax Regs., means "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."
Sec. 1.864-2(c)(2)(i), Income Tax Regs.
Although the general rule is that a dealer in stocks or
securities is ineligible for the exclusion of trading for the
taxpayer's own account, certain types of dealers are excepted
from that general rule by section 1.864-2(c)(2)(iv)(b), Income
Tax Regs., which provides that
A foreign person who otherwise may be considered a
dealer in stocks or securities under (a) of this
subdivision shall not be considered a dealer in stocks
or securities for purposes of this subparagraph-*
*
*
*
*
*
*
(2) Solely because of transactions effected in the
United States in stocks or securities pursuant to his grant
of discretionary authority to make decisions in effecting
those transactions, if he can demonstrate to the
satisfaction of the Commissioner that the broker, commission
agent, custodian, or other agent through whom the
transactions were effected acted pursuant to his written
representation that the funds in respect of which such
discretion was granted were the funds of a customer who is
neither a dealer in stocks or securities, * * * or a foreign
corporation described in subdivision (iii)(b) of this
subparagraph. * * *
For purposes of the foregoing exception (for certain dealers), a
foreign person includes, inter alia, a nonresident alien
- 87 individual and a foreign corporation.
Income Tax Regs.
Sec. 1.864-2(c)(2)(iv)(b),
The exception applies, however, "only if the
foreign person at no time during the taxable year has an office
or other fixed place of business in the United States through
which, or by the direction of which, the transaction in stocks or
securities are effected."
Id.
Section 864(b)(2)(A)(ii) describes the second type of
foreign person that is ineligible for the exclusion of trading
for one’s own account, to wit:
A corporation (other than a corporation which is, or
but for section 542(c)(7), 542(c)(10), or 543(b)(1)(C),
would be, a personal holding company) the principal
business of which is trading in stocks or securities
for its own account, if its principal office is in the
United States.
Petitioners argue that certain of LTD’s trading activities
are eligible to be excluded pursuant to section 864(b)(2)(A)(ii)
from the determination of whether LTD is engaged in "trade or
business within the United States" pursuant to section 864(b).
Specifically, petitioners argue that the transactions LTD
undertook in its own name qualify for exclusion pursuant to
section 864(b)(2)(A)(ii).
Additionally, petitioners contend that
the transactions LTD undertook in its clients' names qualify for
exclusion pursuant to the exception for certain dealers in stocks
or securities provided in section 1.864-2(c)(2)(iv)(b)(2), Income
Tax Regs.
Petitioners argue that the foreign corporation
exception to the exclusion does not apply in the instant case
- 88 because LTD's principal business was not trading in stocks or
securities for its own account and because LTD's principal office
was located outside the United States during each of such years.
Respondent argues that the section 864(b)(2)(A)(ii)
exclusion of trading for the taxpayer's own account does not
apply to any of the transactions in LTD’s financial services
business.
Additionally, respondent argues that the exception in
section 1.864-2(c)(2)(iv)(b)(2), Income Tax Regs., is unavailable
because LTD had an office or other fixed place of business in the
United States.
We agree with respondent.
In the instant case, LTD was
regularly engaged in purchasing certificates of deposit and term
deposits from U.S. and foreign banks as attorney in fact for its
clients and was regularly engaged in selling evidences of an
interest in such financial instruments with a view to making
profits from such transactions.
The certificates of deposit and
term deposits purchased by LTD are "evidences of indebtedness"
and are therefore securities within the meaning of section 1.8642(c)(2)(i), Income Tax Regs.16
The interests in IFF and the non-
U.S. certificates of deposit are "interests in evidences of
indebtedness" and are therefore securities within the meaning of
16
See supra note 13.
- 89 section 1.864-2(c)(2)(i), Income Tax Regs.17
Additionally, LTD
had a fixed place of business in the United States, viz, the San
Antonio office, through which such transactions were effected.
See supra p. 81.
We conclude that none of the transactions in LTD's financial
services business qualify for the exclusion pursuant to section
864(b)(2)(A)(ii).
The transactions that LTD undertook in its own
name were not of the type contemplated by the statute.
LTD did
not purchase and sell securities for its own account for the
purpose of investment or speculation within the meaning of
section 1.864-2(c)(2)(iv)(a), Income Tax Regs.
The transactions
in LTD’s own name were part of its regular, continuous, and
extensive business of purchasing certificates of deposit with its
clients’ funds, as attorney in fact for the clients, with a view
to making commissions or other profits from such transactions.
The office in San Antonio was instrumental to the conduct of that
business.
Based on the foregoing, we hold that LTD did not
effect the transactions in question for its own account within
the meaning of section 864(b)(2)(A)(ii).
Insofar as LTD may have
purchased any of the certificates of deposit for its own account,
we conclude that LTD was "a dealer in stocks or securities"
within the meaning of section 1.864-2(c)(2)(iv), Income Tax
17
Id.
- 90 Regs.18
Consequently, we hold that LTD’s securities trading is
not excluded pursuant to section 864(b)(2)(a)(ii) from the
determination of whether LTD was engaged in "trade or business
within the United States" pursuant to section 864(b).
Petitioners also argue that all of the activities that LTD
performed are excluded by case law from the consideration of
whether LTD was engaged in "trade or business within the United
States" within the meaning of section 864(b).
Petitioners argue
that, "as a matter of law, the fact that INC was or was not a
dependent agent of LTD, or that its offices were or were not
LTD’s offices, is largely irrelevant."
Petitioners contend that
"Whether or not INC was independent will not determine whether
LTD engaged in trade or business within the United States".
Relying on Scottish Am. Inv. Co., Ltd. v. Commissioner, 12 T.C.
49 (1949), petitioners argue that the law concerns itself with
the "character and purpose" of the U.S. activities.
Respondent contends that, pursuant to the facts and
circumstances test of section 1.864-2(e), Income Tax Regs., LTD
was engaged in trade or business within the United States.
Respondent contends that the test for determining if a taxpayer
18
We hold in the instant case that the exception of certain
dealers contained in sec. 1.864-2(c)(2)(iv)(b)(2), Income Tax
Regs., does not apply because LTD had "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" within the meaning of sec. 1.864-2(c)(2)(iv)(b), Income
Tax Regs. See supra pp. 79, 84.
- 91 is engaged in "trade or business within the United States" is
whether substantial profit-oriented activities regularly and
continuously occur in the United States whether carried on
directly by the taxpayer or through agents.
Petitioners rely on a line of cases holding that the mere
maintenance of records and collection of rents, interest, or
dividends through managerial attention to securities does not
constitute trade or business.
See, e.g., Higgins v.
Commissioner, 312 U.S. 212, 218 (1941); Continental Trading, Inc.
v. Commissioner, 265 F.2d 40 (9th Cir. 1959); DeKrause v.
Commissioner, T.C. Memo. 1974-291.
The taxpayer in each of those
cases managed only personal investments and/or personal
investment income.
Because those cases did not address taxpayers
who managed the investments of others, as did LTD, we conclude
that they are not dispositive of the instant case.
Petitioners also cite several cases which are
distinguishable on their facts, to wit:
Piedras Negras
Broadcasting Co. v. Commissioner, 127 F.2d 260 (5th Cir. 1942),
affg. 43 B.T.A. 297 (1941); Abegg v. Commissioner, 50 T.C. 145
(1968), affd. 429 F.2d 1209 (2d Cir. 1970), and Amalgamated
Dental Co. v. Commissioner, 6 T.C. 1009 (1946).
In Piedras
Negras, the court held that none of the taxpayer’s income was
derived from sources within the United States.
Piedras Negras
Broadcasting Co. v. Commissioner, supra at 261.
In the instant
case, we conclude that the main situs of LTD’s income-producing
- 92 activities was the San Antonio office.
Consequently, we conclude
that Piedras Negras does not support petitioners’ position in the
instant case.
In Abegg, the taxpayer engaged in activities that were not
as substantial in both quantity and quality as LTD’s activities
in the instant case.
In Abegg, the taxpayer engaged in
activities solely for its own benefit (viz, collecting dividends
and interest, managing existing investments, and investigating
new investments).
Abegg v. Commissioner, supra at 153-154.
In
contrast, in the instant case, LTD had clients to whom it
provided services and marketed investment products.
Additionally, in Abegg, the taxpayer had operations in the United
States that we characterized as "planning activities", id. at
154, in contrast to LTD’s operations in the instant case, where
LTD’s U.S. operations dealt with third parties and therefore
consisted of more than mere "planning activities".
Consequently,
we conclude that Abegg is not dispositive of the instant case.
In Amalgamated Dental, the Court held that the taxpayer was
not "engaged in trade or business within the United States"
because the relationship between the parties was that of
vendor/vendee.
1015-1016.
Amalgamated Dental Co. v. Commissioner, supra at
We conclude that the facts in the instant case are
distinguishable from those in Amalgamated Dental.
The
relationship between LTD and INC was not that of vendor/vendee.
LTD delegated authority to INC, which, inter alia, purchased
- 93 certificates of deposit in LTD’s name.
Accordingly, we conclude
that Amalgamated Dental is not dispositive of the instant case.
Petitioners also rely heavily on Spermacet Whaling &
Shipping Co. S/A v. Commissioner, 30 T.C. 618 (1958).
In
Spermacet, this Court addressed the issue of whether the taxpayer
was "engaged in trade or business within the United States"
within the meaning of section 231(b) of the 1939 Code, as
amended.
The taxpayer entered into a contract to provide
management services for whaling boats.
The Court held that the
"business in which * * * [the taxpayer] was engaged was that of
managing the [whaling] expedition" and that the taxpayer’s
"activities which produced the income in question took place
almost entirely on the high seas or in Norway."
Id. at 633.
Additionally, the Court held that the activities that the
taxpayer performed within the United States were "without
substance."
Id.
The Court stated:
* * * [the actions in the United States of the
taxpayer’s forty percent shareholder] in receiving
monthly statements or correspondence involving * * *
[the taxpayer], or in paying a limited number of
obligations requiring payment in American dollars out
of a bank account * * * maintained by * * * [the
taxpayer], were ministerial and clerical in nature,
involving very little exercise of discretion or
business judgment necessary to the production of the
income in question. * * * [Id. at 633-634.]
Finally, "The holding of the directors’ meetings in New York City
solely for the personal convenience of the directors was of no
particular consequence."
Id. at 634.
Accordingly, the Court
- 94 stated that "we are convinced that * * * [the taxpayer] was not
engaged in any substantial, regular, or continuous ordinary
business activity in the United States."
Id. at 634.
We conclude that the facts in the instant case are
distinguishable from those in Spermacet.
LTD's activities in the
United States, as conducted by LTD directly and through INC,
exceeded the mere receipt of LTD’s own monthly statements or
correspondence and limited payments of bills from a bank account.
LTD received clients’ funds and placed such funds with third
parties.
Additionally, LTD’s activities in the United States
were more extensive than the taxpayer’s "ministerial and
clerical" activities in Spermacet.
securities in the United States.
LTD traded in stocks or
A substantial part of the
activities that produced LTD’s income took place in San Antonio.
In sum, we conclude that Spermacet Whaling & Shipping Co. S/A v.
Commissioner, supra, is not dispositive of the instant case.
We also conclude that petitioner’s reliance on Scottish Am.
Inv. Co., Ltd. v. Commissioner, 12 T.C. 49 (1949), is without
merit.
In Scottish American, this Court addressed the issue of
whether a group of Scottish trusts, by virtue of the activities
of an office in the United States, were "engaged in trade or
business within the United States" within the meaning of section
231(b) of the 1939 Code, as amended.
following facts:
The Court found the
- 95 All judgments as to investments, the purchase and
sale of securities, and substantially all other major
policy decisions were made by officers in the home
office of the trusts situated outside of the United
States; orders for purchase and sale of securities were
executed by * * * [the trusts] directly through
resident banks in the United States; * * * the American
office’s activities were * * * confined to routine and
clerical functions performed by the banks prior to
1936. * * * [Id. at 55-56; fn. ref. omitted.]
The trusts' office, located in Jersey City, New Jersey,
performed the following activities:
Collected, verified,
deposited, and remitted to the trusts dividend and interest
payments; exercised voting rights; maintained records for the
trusts; obtained and forwarded investment information to the
trusts; prepared tax returns; leased an office; and paid
expenses.
Id. at 56-57.
The Court held that the Scottish trusts were not "engaged in
trade or business within the United States" within the meaning of
former section 231(b), as amended.
The Court reasoned that
the real business of * * * [the trusts], the doing of
what they were principally organized to do in order to
realize profit, was the cooperative management in
Scotland of British capital, a large part of which was
invested by them in American securities through
transactions effected through resident brokers. To
this business of * * * [the trusts], the business
activities of the American office were merely helpfully
adjunct. No consequential transactions were effected
through or by the direction of the Jersey City office.
It functioned primarily as a clerical department
performing a number of useful routine and incidental
services for * * * [the trusts]. But it can not be
said here that the local office, even though we look at
its activities as a whole, was doing what was
principally required to be done by * * * [the trusts]
- 96 in order to realize profit, or that its activities
constituted a business which * * * [the trusts] carried
on within the United States. * * * [Id. at 59; fn.
ref. omitted.]
The Court observed that, with respect to cases involving a
determination of whether or not a taxpayer is "engaged in trade
or business within the United States", "it is a matter of degree,
based upon both a quantitative and a qualitative analysis of the
services performed, as to where the line of demarcation should be
drawn."
Id.
The Court concluded that "It is not so much the
volume of the activities of the Jersey City office, although
volume of activities may, in some cases, be a factor, but rather
their character and the purpose for which the office is
established that we believe are determinative."
Id.
The Court
stated:
We are not convinced that the services of this local
office, quantitatively extensive and useful as they may
have been, approached that quality which is necessary
in order that * * * [the trusts] can be characterized
as having engaged in business in the United States
during the years involved within the meaning of section
231(b). * * * [Id.]
The facts in the instant case are distinguishable from those
in Scottish American.
In Scottish American, the trusts’ office
in the United States did not effect the trusts’ trading; the
trusts’ orders for purchases and sales of securities "were sent
directly from Scotland to resident brokers in the United States."
Id. at 56.
The trusts’ resident brokers were also their resident
banks, J.P. Morgan & Co. and the National City Bank of New York.
- 97 Id. at 51.
The trusts’ office in the United States was advised
of the purchases and sales executed by the resident brokers "so
that it would make the proper entries on its books."
Id. at 56.
Unlike the trusts in Scottish American, LTD did not use
independent resident brokers to effect transactions in securities
for its own account during the years in issue.
Rather, LTD’s
business consisted primarily of trading for its clients’ accounts
through transactions effected by its wholly owned subsidiary INC
at the latter’s office in the United States.
In sum, we conclude
that Scottish American is not dispositive of the instant case.
Consequently, we conclude that case law does not allow LTD to
exclude any of its trading activities from the consideration of
whether it was engaged in "trade or business within the United
States" pursuant to section 864(b).
One final inquiry into the issue of whether LTD was engaged
in "trade or business within the United States" remains.
Although LTD’s trading activities are not eligible for exclusion
from "the performance of personal services" for purposes of
section 864(b), LTD is not automatically deemed to be engaged in
"trade or business within the United States."
Income Tax Regs.
Sec. 1.864-2(e),
The fact that a party "is not determined by
reason of this section to be not engaged in trade or business
within the United States is not to be considered a determination
that such person is engaged in trade or business within the
United States."
Id.
Whether such a person is engaged in trade
- 98 or business within the United States "shall be determined on the
basis of the facts and circumstances in each case."
Id.
Accordingly, pursuant to section 1.864-2(e), Income Tax
Regs., we apply the relevant case law, which provides tests
regarding the amount of activity that is required for a
conclusion that a taxpayer is engaged in "trade or business
within the United States" pursuant to section 864(b).
Finding no
cases addressing the term "trade or business within the United
States" as used in section 864(b), we turn to the cases
interpreting the statutory precursors of section 864 and section
882(a).
In European Naval Stores Co., S.A. v. Commissioner, 11 T.C.
127 (1948), the Court addressed whether the taxpayer, a foreign
corporation, was “engaged in trade or business within the United
States” within the meaning of section 231(b) of the 1939 Code, as
amended.
In interpreting former section 231(b), the Court held
that the "question as to what activities of a taxpayer constitute
the carrying on of a business is one of fact."
Id. at 132
(citing Higgins v. Commissioner, 312 U.S. 212 (1941), which
interpreted the phrase "carrying on any trade or business" within
the meaning of section 23(a) of the Revenue Act of 1932 (a
precursor of section 162(a))).
The Court in European Naval
Stores indicated that the phrase "engaged in trade or business
within the United States" refers to profit-seeking activities
that are sufficiently regular, continuous, and extensive to
- 99 constitute "carrying on a trade or business" within the meaning
of section 162.
The Court added:
The meaning of the phrases "engaged in business,"
"carrying on business," and "doing business" were
defined by the Circuit Court of Appeals for the Third
Circuit in Lewellyn v. Pittsburgh, B. & L.E.R. Co., 222
Fed. 177. It was stated therein that, "The three
expressions, either separately, or connectedly, convey
the idea of progression, continuity, or sustained
activity. 'Engaged in business' means occupied in
business; employed in business. 'Carrying on business'
does not mean the performance of a single disconnected
business act. It means conducting, prosecuting, and
continuing business by performing progressively all the
acts normally incident thereto, and likewise the
expression 'doing business', when employed as
descriptive of an occupation, conveys the idea of
business being done, not from time to time, but all the
time. * * *". [Id. at 133.]
In Scottish Am. Inv. Co., Ltd. v. Commissioner, 12 T.C. 49
(1949), the Court addressed whether the taxpayers, foreign
investment trusts, were, by virtue of maintaining a U.S. office,
"engaged in trade or business within the United States" within
the meaning of section 231(b) of the 1939 Code, as amended.
The
Court examined "the real business of * * * [the taxpayers], the
doing of what they were principally organized to do in order to
realize profit".
Id. at 59 and n.14 (citing Edwards v. Chile
Copper Co., 270 U.S. 452, 455 (1926)).
In Scottish American, the
Court decided that the taxpayers’ real business was "the
cooperative management in Scotland of British capital" and that
"the business activities of the American office were merely
helpfully adjunct."
Id. at 59.
Additionally, the Court stated
- 100 that, "In cases such as these * * * [regarding whether the
taxpayer is engaged in trade or business within the United
States], it is a matter of degree, based upon both a quantitative
and a qualitative analysis of the services performed, as to where
the line of demarcation should be drawn."
Id.
In Scottish
American, the Court decided that the factors to be examined were
the "character" of the activities performed in the U.S. office,
"the purpose for which the office * * * [was] established", and,
to a lesser extent, "the volume of the activities".
Id.
In Spermacet Whaling & Shipping Co. S/A v. Commissioner, 30
T.C. 618 (1958), the Court addressed whether the taxpayer, a
foreign corporation, was "engaged in trade or business within the
United States" within the meaning of section 231(b) of the 1939
Code, as amended.
In interpreting former section 231(b), the
Court stated:
We have consistently held that before a taxpayer
can be found to be "engaged in trade or business within
the United States" it must, during some substantial
portion of the taxable year have been regularly and
continuously transacting a substantial portion of its
ordinary business in this country. * * * [Id. at 634
and n.10 (citing, inter alia, European Naval Stores
Co., S.A. v. Commissioner, supra, and Scottish American
Investment Co. v. Commissioner, supra).]
After summarizing the test pursuant to former section 231(b), the
Court concluded that the taxpayer was not "engaged in any
substantial, regular, or continuous ordinary business activity in
the United States."
Id. at 634.
- 101 Petitioners contend that LTD’s "real business" was "to
render investment advice to clients in Mexico."
Accordingly,
petitioners argue that all of the activities relating to LTD’s
business occurred in Mexico:
LTD’s clients were solicited and
advised by Mexican-based promoters in Mexico, their accounts were
opened and approved in Mexico, clients changed their investment
portfolios in consultation with their Mexican promoter, and the
spread (where applicable) was negotiated in Mexico.
Petitioners
contend that INC performed merely ministerial activities in the
United States and did not render any investment advice to clients
in Mexico.
On those premises, petitioners conclude that LTD’s
"real business"--even if INC’s activities were imputed to LTD-did not occur in the United States.
We disagree.
Contrary to petitioners’ argument, we believe
that the term "performance of personal services within the United
States" for purposes of section 864(b) does not require that LTD
itself perform such "personal services" in order to be engaged in
"trade or business within the United States."
We first look to the "real business" of the taxpayers, the
"doing of what * * * [the taxpayers] were principally organized
to do in order to profit".
Scottish Am. Inv. Co., v.
Commissioner, supra at 59.
LTD is a corporation organized
pursuant to the laws of the Cayman Islands.
Based on the record,
we believe that the "real business" of LTD, the doing of what LTD
- 102 was "principally organized to do in order to realize profit", was
to enable Mexican nationals to invest their capital in nonMexican financial markets.
LTD’s "real business" was not merely
to render investment advice to clients in Mexico, as petitioners
contend.
During each of the years in issue, LTD’s income
consisted of four major categories:
Management fees, interest
income, currency transactions fees, and other fees and
commissions.
LTD’s income, therefore, was derived from
effecting, primarily in the United States, transactions in
financial markets.
Accordingly, we conclude that LTD’s "real
business" was providing Mexican nationals with access to nonMexican financial markets and that such business was conducted
primarily in the United States.
In Scottish Am. Inv. Co. v. Commissioner, supra at 59, the
Court made "a quantitative and a qualitative analysis of the
services performed".
Quantitatively, LTD performed a substantial
number of services in the United States.
LTD maintained a client
clearing account at Frost Bank in San Antonio in which it
collected deposits from clients.
During the years in issue, LTD
had approximately the following number of client accounts:
257
during 1985, 434 during 1986, 557 during 1987, 870 during 1988,
and 1,131 during 1989.
traded.
Not all client accounts were actively
Nonetheless, we conclude that the number of LTD’s client
accounts, and, as a corollary, the number of services performed
- 103 in the United States for such accounts, during each of the years
in issue, can be characterized as quantitatively substantial.
Qualitatively, LTD performed substantial services in the
United States.
Directly and through its agent INC, LTD provided
investment management services and marketed investment products.
The purpose for which LTD was established was to provide access
to non-Mexican financial markets, and LTD conducted such business
primarily in the United States.
We therefore conclude that LTD’s
activities in the United States during each of the years in issue
can be characterized as qualitatively substantial.
In sum, we conclude that LTD "engaged in * * * substantial,
regular, or continuous ordinary business activity in the United
States."
Spermacet Whaling & Shipping Co. S/A v. Commissioner,
supra at 634.
We find that LTD’s activities in the United
States, conducted directly or through agents, included:
Receiving client funds, monitoring interest rates, effecting
trades, collecting and disbursing dividends and interest,
maintaining customer account information, and valuing portfolios.
Accordingly, we conclude that, during the years in issue, LTD was
"engaged in business in the United States" within the meaning of
section 1.864-4(c)(5)(i), Income Tax Regs.
Consequently, we hold
that LTD was "engaged in the active conduct of a banking,
financing, or similar business in the United States" pursuant to
section 1.864-4(c)(5)(i), Income Tax Regs.
A fortiori, we hold
that LTD was engaged in "trade or business within the United
- 104 States" pursuant to section 864(b) for its taxable years June 30,
1985 through 1989.
B.
Whether Each Item of LTD's Income
Was Effectively Connected
1.
Character and Source Rules
Before deciding whether an item of income is "effectively
connected with the conduct of trade or business within the United
States" pursuant to section 882(a)(1), we must first decide the
character and source of each item of income.
Items of income
include, inter alia, personal services income and interest
income.
Secs. 861(a) and 862(a).
An item may be classified as
income from sources within the United States pursuant to section
861, as income from sources without the United States pursuant to
section 862, or as income partly from within and partly from
without the United States pursuant to section 863(b).
Generally, income from the performance of personal services
has its source where the services are performed.
Absent an
exception not applicable in the instant case, compensation for
labor or personal services performed in the United States is
treated as income from sources within the United States.
861(a)(3).
Sec.
Compensation for labor or personal services performed
without the United States is treated as income from sources
without the United States.
Sec. 862(a)(3).
For LTD's taxable years ended June 30, 1985 and 1986,
generally, the source of interest depends on the residence of the
- 105 obligor.
Interest on bonds, notes, or other interest-bearing
obligations of U.S. residents, corporate or otherwise, is
generally treated as income from sources within the United
States.
Sec. 861(a)(1).
The term "resident of the United
States", used in section 1.861-2(a)(1), Income Tax Regs.
(promulgated pursuant to
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