SDI Netherlands B v. v. Commissioner

* *49 * * *

8.3 All royalties payable to [SDI Bermuda] under this Agreement shall be due within 28 days from the moment that the royalties to be paid by the Sublicensees shall be due to [petitioner]. All royalties payable to [SDI Bermuda] under this Agreement, will be paid by [petitioner] at the option of the [petitioner], in the same currency or in U.S. Dollars in which the royalties due to [petitioner] are payable.

8.4 [Petitioner] shall annually provide [SDI Bermuda] with a survey of all royalties due by the Sub-licensees and pay [SDI Bermuda] in accordance with subsection 8.1 hereof. Any additional payments due to [SDI Bermuda] pursuant to subsection 8.2 shall be made immediately after the approval of the annual accounts of [petitioner]. [SDI Bermuda] has the right to have a representative examine [petitioner's] accounts.

Petitioner made royalty payments to SDI Bermuda, pursuant to the Bermuda license agreement, during the years in issue, in the following amounts:

The above payments constituted the following percentages of the total worldwide royalty payments received by petitioner with respect to*50 the software:

Royalty Payments Received by Petitioner from SDI USA

During the years in issue, petitioner was a party to an exclusive license agreement with SDI USA, dated October 1, 1972, and as modified from time to time, regarding the use and licensing of the software in the United States (the U.S. license agreement). ⁴ SDI USA was responsible for the direct marketing and sales of the software in the United States.

The U.S. license agreement provided in part:

2.1 In consideration for the payment of the royalties provided hereunder and the performance of the other terms and conditions hereof by [SDI USA], [petitioner] hereby grants and transfers to [SDI USA], upon*51 the terms and subject to the conditions hereinafter set forth, the exclusive right and license during the Term hereof, to have disclosed to it by [petitioner] and to exploit, use and lease and otherwise obtain the benefit of [the software] within the Territory.

2.2 This Exclusive License shall include, (i) the right to sublicense to others the use and lease of [the software] within the Territory, subject, however, to the terms and conditions of this License; and (ii) this License shall also include the right and, as hereinafter provided, the obligation of [SDI USA], to provide or to provide for the exclusive maintenance, servicing and repair of [the software] within the Territory. * * *

* * * *

2.4 The Territory of this License shall mean and be restricted to the continental United States, Hawaii and Alaska.

Petitioner agreed not to license the software for use or to compete directly or indirectly with SDI USA's exploitation of the software in the United States during the term of its license to SDI USA. ⁵

*52 Until February 1987, the agreement provided that SDI USA would pay to petitioner "an annual royalty equal to fifty percent *166 (50%) of the annual gross revenues of [SDI USA] from leasing and sublicensing of [the software], without any deductions therefrom except rebates, discounts and sales or value added taxes."

The U.S. license agreement was modified in February 1987 to provide that SDI USA would pay petitioner "a royalty equal to (50%) fifth percent of the gross billable or invoiced revenues of [SDI USA] with regard to all products licensed herein or further licensed in the future, without any deductions therefrom except rebates, or, sales or value added taxes."

Petitioner received royalty payments pursuant to the U.S. license agreement from SDI USA, during the years in issue, in the following amounts:

Respondent mailed notices of deficiency to petitioner, one for 1987, 1988, and 1989, and one for 1990, on July 29, 1994.

The parties have stipulated the amounts of royalties received by petitioner from SDI USA and paid by petitioner to SDI Bermuda. As a consequence, it appears that these amounts, if subject*53 to withholding tax, would produce deficiencies greater than those determined in the notices of deficiency for 1987, 1988, and 1990 and a lesser amount for 1989. Respondent has made no specific request for any increased deficiencies.

Discussion

Increased Deficiencies

Section 6214(a) provides that this Court has jurisdiction to determine an increased deficiency "if claim therefor is asserted * * * at or before the hearing or a rehearing". Under the circumstances herein, where the amounts upon which the mathematical calculation of the withholding tax is based have been stipulated by the parties and where the issue upon which the liability for both the original and the increased deficiencies depends is the same, we think that *167 respondent has made a timely claim for the increased deficiencies and see no reason to preclude our consideration of such increases. See Pallottini v. Commissioner, 90 T.C. 498, 500 (1988); cf. Law v. Commissioner, 84 T.C. 985, 989 (1984). ⁶ Indeed, as we understand petitioner's position, it does not oppose such consideration except in the context of its contention that the burden of proof*54 should in any event be shifted to respondent under Rule 142(a).

Burden of Proof

Petitioner argues that the notices of deficiency refer only to section 1441, so that reliance by respondent on section 1442 constitutes a new matter on which respondent has the burden of proof under Rule 142(a). That burden of proof would, according to petitioner, require respondent to prove that, during the years in issue, SDI Bermuda was not engaged in a trade or business within the United States or, if so engaged, that the royalties received from petitioner by SDI Bermuda were not effectively connected with such trade or business ⁷; if SDI Bermuda were so engaged and the royalties so connected, no withholding would be necessary. ⁸ See secs. 1441(c), 1442(a) and (b), 881(a); *55 secs. 1.1442-2, 1.1441-4, Income Tax Regs.

Initially, we deal with petitioner's position in respect of the burden of proof without regard to the increases in deficiencies for 1987, 1988, and 1990. In this connection, we note that the fact that the case has been fully stipulated does not alter the application of the burden of proof rules. Rule 122(b); Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. on other grounds 943 F.2d 22 (8th Cir. 1991).*56

In Zarin v. Commissioner, 92 T.C. 1084, 1088-1089 (1989), revd. on other grounds 916 F.2d 110 (3d Cir. 1990), we set forth the following frame of reference for determining what is new matter within the meaning of Rule 142(a):

*168 Rule 142(a) provides that the burden of proof is on petitioner, "except that, in respect of any new matter, increases in deficiency, and affirmative defenses, pleaded in his answer, it shall be upon the respondent." A new position taken by respondent is not necessarily a "new matter" if it merely clarifies or develops respondent's original determination without requiring the presentation of different evidence, being inconsistent with respondent's original determination, or increasing the amount of the deficiency. Achiro v. Commissioner, 77 T.C. 881, 889-891 (1981).

The notices of deficiency herein provide in pertinent part:

The payments you made to nonresident aliens in the amounts shown are subject to the withholding rate provided by section 1441(a) of the Internal Revenue Code. Since you did not withhold the tax, and did not establish that the recipient of *57 the payments paid the United States tax, you are liable for the tax that should have been withheld. * * *

We think that section 1441, which imposes the withholding tax on nonresident alien individuals and foreign partnerships, was cited only for the rate of tax applied by respondent. Respondent cited no section for the source of the deficiencies, nor, indeed, was respondent required to do so. Jarvis v. Commissioner, 78 T.C. 646, 655-656 (1982). The language of the notices did not, directly or by necessary inference, exclude a claim under section 1442, which imposes the withholding tax on foreign corporations and upon which respondent proceeds herein. Moreover, section 1442 makes reference to and incorporates section 1441 so that reference to section 1441 is entirely appropriate in a proceeding under section 1442. See Central de Gas de Chihuahua, S.A. v. Commissioner, 102 T.C. 515, 517 (1994). Beyond this, the very elements of section 1442 upon which petitioner relies to shift to respondent the burden of proof, i.e., the burden of proving that SDI Bermuda was not engaged in trade or business within the United States or, *58 if so engaged, that the royalties were not effectively connected with such trade or business, are also present in the application of section 1441. See also secs. 1.1442-2 and 1.1441-4, Income Tax Regs. Compare sec. 1442(b)⁹*59 with sec. 1441(c)¹⁰. Thus, there is no *169 inconsistency in applying section 1442 rather than section 1441 herein since similar evidence is involved in providing a basis for determining whether or not a taxpayer is exempt from withholding under either section. Inconsistency and the absence of a need for different evidence are critical elements in deciding whether a "new matter" is involved that requires that the burden of proof be shifted to respondent. See Zarin v. Commissioner, supra;Estate of Emerson v. Commissioner, 67 T.C. 612, 620 (1977).

Finally, we note that petitioner itself contributed to any confusion that may have existed in respect of the applicability of section 1442 or section 1441, referred to in the notices of deficiency. Prior to the time the notices of deficiency were prepared, respondent had received limited information regarding the royalty payments at issue. In particular, it was unclear to whom, and in what amount, the royalty payments were being made. Only just prior to the date set for trial and after prodding by the Court did petitioner come forth with evidence as to whom and in what amounts the royalties were paid.

In sum, since the essential elements of proof*60 are the same under the circumstances herein whether seciton 1441 or section 1442 provides the key to decision, there is no surprise or unfairness in rejecting petitioner's contention that the burden of proof should be shifted to respondent. See Stewart v. Commissioner, 714 F.2d 977, 990-991 (9th Cir. 1983), affg. T.C. Memo. 1982-209. ¹¹

Liability for Withholding

Section 881(a) provides that a 30-percent tax shall be imposed on "the amount received from sources within the United States by a foreign corporation" falling within certain categories of income. ¹²Section 1442 provides a method for *170 collecting that tax. Central de Gas de Chihuahua, S.A. v. Commissioner, 102 T.C. at 519.

*61

Section 1442 provides in part:

(a) General Rule.-- In the case of foreign corporations subject to taxation under this subtitle, there shall be deducted and withheld at the source in the same manner and on the same items of income as is provided in section 1441 a tax equal to 30 percent thereof. * * *

Royalties are among the types of income included in section 1441(b). Sec. 1.1441-2(a), Income Tax Regs.; see also sec. 1.881-2(b), Income Tax Regs. In addition, section 861(a)(4) provides that U.S. source income includes:

(4) Rentals and Royalties.-- Rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using in the United States patents, copyrights, secret processes and formulas, good will, trade-marks, trade brands, franchises, and other like property.

Section 1441(a) completes the picture of the statutory provisions involved herein. It provides:

all persons * * * having the control, receipt, custody, disposal, or payment of any of the items of income specified in subsection (b) [which includes "royalties"] (to the extent that any of such items constitutes*62 gross income from sources within the United States), of any nonresident alien individual or of any foreign partnership shall * * * deduct and withhold from such items a tax equal to 30 percent thereof * * *

There can be no dispute that the royalty payments received by petitioner from SDI USA constitute U.S. source income and were received by petitioner as such within the meaning of section 1442(a). See Commissioner v. Wodehouse, 337 U.S. 369 (1949); see also Estate of Marton v. Commissioner, 47 B.T.A. 184 (1942). However, royalties paid by SDI USA to petitioner are exempt from taxation by virtue of section 894 and article IX of the United States-Netherlands Income Tax Convention, April 29, 1948, 62 Stat. 1757, 1762, 1950-1 C.B. 92, as amended by the Supplementary Protocol, June 15, 1955, 6 U.S.T. 3696, 1956-2 C.B. 1116, and as further amended by the United States-Netherlands Supplementary Income Tax Convention, Dec. 30, 1965, 17 U.S.T. 896, 1967-2 C.B. 472 (U.S.-Netherlands treaty); see also sec. 894. There is no comparable U.S. treaty *63 exemption that *171 would apply to royalty payments from SDI USA to SDI Bermuda.

The parties have locked horns on several aspects of the application of the statutory provisions in light of the impact of the U.S.-Netherlands treaty exemption: (1) Whether the royalties paid by petitioner to SDI Bermuda constitute income "received from sources within the United States by" SDI Bermuda and are thus subject to withholding under section 1441(a); (2) whether petitioner can be considered a "withholding agent"; (3) whether there is a limitations period that has expired in respect of respondent's right to assess a deficiency in withholding tax against petitioner; and (4) whether petitioner is liable for additions to tax under section 6651(a)(1) for failure to file withholding tax returns.

For reasons hereinafter set forth, we resolve the first issue in petitioner's favor with the result that it is unnecessary for us to address the remaining issues.¹³ Before proceeding with our analysis of the first issue, however, it is important to note that respondent does not question the existence of petitioner as a valid Netherlands corporation or the application of the treaty exemption insofar as the payments*64 by SDI USA to petitioner are concerned. Similarly, respondent does not attack the arrangements under which petitioner had a license of the worldwide rights and SDI USA had a license of the U.S. rights, although respondent does ask us to take into account the close relationship of the various corporations involved. Compare Gaw v. Commissioner, T.C. Memo. 1995-531, on appeal (D.C. Cir., May 20, 1996).

Rather, respondent focuses her argument solely on the proposition that, since the royalties paid by SDI USA to petitioner were U.S. source income, *65 they retained that character as part of the royalties paid by petitioner to SDI Bermuda and, as a matter of law, constitute income "received from sources within the United States by" SDI Bermuda under section 881(a).¹⁴ Respondent contends that the fact that such royalties were combined with non-U.S. source royalties *172 received by petitioner to determine the amount of royalties payable by petitioner to SDI Bermuda does not preclude the tracing of the royalties received by petitioner from SDI USA to U.S. sources. To implement such tracing, respondent simply applies the percentage specified in the worldwide license agreement between petitioner and SDI Bermuda and utilized in computing the amount of the required payment by petitioner to SDI Bermuda. To support her contention that such an allocation is permissible, respondent cites Wodehouse v. Commissioner, 15 T.C. 799 (1950); Rohmer v. Commissioner, 14 T.C.1467 (1950); Rohmer v. Commissioner, 5 T.C. 183 (1945), affd. 153 F.2d 61 (2d Cir. 1946); Estate of Marton v. Commissioner, 47 B.T.A. 184 (1942); Molnar v. Commissioner,