Flume II: The Tax Court’s Recent Decision Involves UBS of Switzerland and Controlled Foreign Corporations
Flume v. Comm’r, T.C. Memo. 2020-80 | June 9, 2020 | Ashford, J. | Dkt. No. 31162-14
Short Summary: The IRS issued notices of deficiency to the taxpayers for tax years 2006, 2007, and 2008 related to income associated with foreign entities. The underlying case ultimately arose, in part, out of an audit prompted by the IRS’s receipt of records from Union Bank of Switzerland (UBS) pertaining to a UBS account held by a Bahamian entity owned by the taxpayers. That information was provided to the IRS in response to a request for treaty information.
This case, which will become known at “Flume II,” also arose in connection with a prior Tax Court case in which the taxpayer-petitioners were involved. In Flume v. Commissioner (Flume I), T.C. Memo. 2017-21, a collection due process case, the issue for decision was whether Mr. Flume was liable for assessed civil penalties under sections 6038 and 6679 for his failure to declare (via Forms 5471) his ownership interest in Wilshire for the 2001-09 taxable years (and his ownership interest in FFM for the 2001 and 2002 taxable years). In deciding the issue, the Court had to determine whether Wilshire was a CFC for years that included the years at issue in the instant case. The Court determined that petitioners each held 50% ownership interests in Wilshire throughout a period that included the subject years. Those determinations became important with respect to Flume II under issue preclusion principles.
During the years at issue and when the petition was filed petitioners were U.S. citizens residing in Mexico
Franchise Food Services de Mexico S.A. de C.V. (FFM) is a Mexican sociedad anonima, which is a limited liability stock corporation that adopted the form of a variable capital company. FFM was incorporated in Guadalajara, Jalisco, Mexico, in 1995 to operate two fast food franchises that Mr. Flume owned.
Initially there were two 50% shareholders of FFM, Mr. Flume and Norwick Adams. Mr. Flume was FFM’s president, and Mr. Adams was FFM’s secretary and treasurer. The fast food franchises were sold in 1998, but FFM remained intact, having at least one U.S. bank account.
On February 8, 2002, Mr. Flume transferred 41% of his 50% ownership interest in FFM to Victor Mendez Tornell.
During the years at issue FFM was an active corporation. On January 15, 2007, petitioners entered into a consulting and personal services contract with FFM, and FFM made payments to them for their services.
In addition, the petitioners incorporated Wilshire Holdings, Inc. (Wilshire), in the Bahamas, with each holding one bearer share of Wilshire capital stock.
During Wilshire’s February 23, 2000, organizational meeting Mr. Flume was named as Wilshire’s director and secretary. The following year petitioners changed the domicile of Wilshire, reincorporating it in Belize. At a time not established by the record petitioners amended Wilshire’s original Belizean articles of association. These amended articles of association were backdated to April 12, 2001, to reflect the date of original incorporation in Belize. As stated in these amended articles of association petitioners’ bearer shares in Wilshire were eliminated and they and their daughter each held a 9% ownership interest, and Mr. Tornell held the remaining 73% ownership interest in Wilshire. During at least the years at issue Mr. Flume was the president and a director of Wilshire, and Mrs. Flume was the vice president and a director of Wilshire.
Petitioners opened bank or brokerage accounts in Wilshire’s name with Laredo National Bank (now BBVA Compass Bank) in 2000 (BBVA Compass Bank account), United Bank of Switzerland (UBS) in 2005 (UBS account), and Fidelity Investments at a time not established by the record (Fidelity account). They had sole signature authority over each of these accounts. The BBVA Compass Bank account was opened in the United States using a U.S. identification number petitioners obtained for Wilshire. The UBS account was opened outside the United States, and in doing so petitioners provided UBS with (among other documents) Wilshire’s original memorandum and articles of association and a certificate of incumbency for Wilshire from the Corporate Services Division of the Belize Bank Limited in Belize City, Belize. The certificate of incumbency identified Mr. Flume as Wilshire’s sole director and Wilshire’s shareholders as two “[b]earers” holding one share each of its capital stock. UBS’ due diligence documents identified petitioners as the beneficial owners of the UBS account, Mr. Flume as Wilshire’s “only shareholder and owner”, and the account’s purpose as “[w]ealth [m]anagement of retirement funds; probably [a] loan for [a] flat in Paris.” It is unknown how the Fidelity account was opened.
Wilshire did not compensate petitioners by check or direct deposit for the years at issue; instead, it would transfer funds from its BBVA Compass Bank, UBS, and Fidelity accounts to petitioners’ personal accounts or directly pay some of their personal expenses. Payments made by Wilshire of petitioners’ personal expenses during the years at issue include payments of their personal credit card charges, travel expenses, household furnishings, automatic teller machine withdrawal service charges, tuition, gifts to relatives, and rent for an apartment in San Francisco, California. In addition Wilshire would transfer funds from its BBVA Compass Bank account to FFM “in lieu of salary” to petitioners.
SMA Property Development
On January 15, 2007, FFM and Wilshire entered into a five-year joint venture agreement to acquire, develop, and sell residential real property in Mexico. This joint venture of FFM and Wilshire operated under the name SMA Property Development (SMA). Petitioners managed the affairs and funds of SMA, and more specifically, Mr. Flume served as SMA’s managing partner. On January 15, 2007, petitioners were also given powers of attorney to act jointly and independently as the attorneys-in-fact of SMA. As SMA’s attorneys-in-fact they were authorized to retain any assets owned by SMA and reinvest those assets, co-own assets and commingle their funds with the funds of SMA, and personally gain from any transaction they completed on SMA’s behalf.
The IRS determined that Wilshire was a controlled foreign corporation (CFC) that was 100% owned by petitioners for the years at issue, that the investment income from Wilshire’s UBS and Fidelity accounts was foreign personal holding company income (FPHCI) under subpart F of the Code, and that as a result petitioners were required to report their pro rata share (100%) of that FPHCI as subpart F income (and taxable as additional ordinary dividend income).
In the alternative, the IRS determined that petitioners were required to report as ordinary income: (1) interest income attributable to Wilshire’s UBS and Fidelity accounts; (2) ordinary dividend income attributable to Wilshire’s UBS and Fidelity accounts ; and (3) capital gains attributable to Wilshire’s UBS and Fidelity accounts.
The case involved three substantive issues: whether petitioners (1) had additional wage income, (2) had reportable subpart F income, and (3) are liable for accuracy-related penalties
A subsidiary issue bearing on whether the taxpayers had addition subpart F income was whether Wilshire was a CFC on any day during each of the years at issue with the result that if Wilshire was such a CFC then petitioners have reportable subpart F income for those years.
- The conditions for issue preclusion are satisfied (as a result of the prior proceedings in Flume I), rendering Wilshire a CFC during the years at issue.
- Given that the taxpayers were 100% shareholders of Wilshire for the years at issue, their pro rata share of Wilshire’s subpart F income for those years was 100%.
- The penalties here were approved in writing before the first formal communication to petitioners of those penalties.
- Held that Petitioners did not rely on their tax-return preparer’s “judgment” (let alone reasonably rely on her “judgment”), nor did they act in good faith. Petitioners have failed to prove that they had reasonable cause within the meaning of section 6664(c).
Key Points of Law:
- In general, the IRS’s determinations set forth in a notice of deficiency are presumed correct and, except for the burden of production in any court proceeding with respect to a taxpayer’s liability for any “penalty, addition to tax, or additional amount”, see sec. 7491(c), the taxpayer bears the burden of proving otherwise.
- However, for this presumption to adhere in cases (such as this one) involving unreported income, the Commissioner must provide some reasonable foundation connecting the taxpayer with the income-producing activity.
- A taxpayer’s gross income includes “all income from whatever source derived,” including “[c]ompensation for services”, e.g., wages and salaries. Sec. 61(a)(1); sec. 1.61-2(a)(1), Income Tax Regs.
- A taxpayer is required to maintain books or records sufficient to establish the amount of his or her gross income required to be shown by such person on any return. See sec. 6001; sec. 1.6001-1, Income Tax Regs.
- If the taxpayer’s books or records do not clearly reflect income, then the Commissioner is authorized “to reconstruct income in accordance with a method which clearly reflects the full amount of income received.”
- The specific item method is a Court-approved “method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.”
- Under the Controlled Foreign Corporation (CFC) statutory scheme, a U.S. shareholder of a CFC must generally include in his gross income his pro rata share of the CFC’s “subpart F income” for such year. see sec. 951(a)(1).
- Section 951(b) defines a U.S. shareholder, with respect to any foreign corporation, as a U.S. person “who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote” of the foreign corporation. Section 957(a) generally defines a CFC as “any foreign corporation if more than 50 percent of–(1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is [directly or constructively] owned * * * by United States shareholders on any day during the taxable year of such foreign corporation.”
- Section 952(a)(2) defines subpart F income as including foreign base company income as determined under section 954. Under section 954(a)(1) and (c)(1), foreign base company income includes “foreign personal holding company income”, which in turn includes dividends, interest, and the excess of gains over losses from the sale or exchange of certain property.
- Issue preclusion “recognizes that suits addressed to particular claims may present issues relevant to suits on other claims.”
- Issue preclusion applies when suits involve separate claims, but present some of the same issues, and ‘bars the relitigation of issues actually adjudicated, and essential to the judgment, in a prior litigation between the same parties.
- Issue preclusion focuses on whether (1) the issue in the second suit is identical in all respects with the one actually litigated, decided, and essential to the judgment in the first suit, (2) a court of competent jurisdiction rendered a final judgment in the first suit, (3) the controlling facts and applicable legal principles in the second suit have changed significantly since the judgment in the first suit, and (4) there are special circumstances, such as fairness concerns, that warrant an exception to preclusion in the second suit.
- The pro rata amount that a U.S. shareholder of a CFC reports as subpart F income of the CFC for any taxable year cannot exceed the CFC’s current earnings and profits. Sec. 952(c)(1)(A)
- A CFC’s current earnings and profits are generally “determined according to rules substantially similar to those applicable to domestic corporations”.
- The Code does not define the term “earnings and profits” for domestic corporations. A domestic corporation’s earnings and profits “is generally understood to equal the corporation’s taxable income for the taxable year with certain modifications.”
- Section 6751(b)(1) requires that the initial determination of certain penalties be “personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”
- Reasonable cause may exist where the taxpayer relies on professional advice if the taxpayer proves by a preponderance of evidence that: (1) the adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him or her; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment.
Insight: Taxpayers with interests in foreign entities are often subject to complex reporting regimes, such as the CFC reporting regime, which taxes a U.S. shareholder’s allocable share of “subpart F” income earned by a CFC, whether or not the CFC actually repatriates/distributes that income to the U.S. shareholder. The case is also yet another reminder of the significant increase in the IRS’s focus on international tax reporting deficiencies, and its continuing ability to obtain information from foreign jurisdictions and sources.
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