                         T.C. Memo. 1997-134



                       UNITED STATES TAX COURT



                    ALBERT J. MILLER, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 22733-92.              Filed March 17, 1997.



     Lawrence V. Brookes, for petitioner.

     Ewan D. Purkiss and Andrew P. Crousore, for respondent.


                          MEMORANDUM OPINION

     KÖRNER, Judge:    This case is before the Court on

petitioner's motion for summary judgment as supplemented under

Rule 121.1    Respondent determined that petitioner, acting as

general partner of certain limited partnerships, was personally


     1
        All statutory 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, except as
otherwise noted.
                               - 2 -

liable under section 1461 for his failure to withhold tax due

under section 881, as required by section 1442, on payments made

by such limited partnerships to A-Alphatronics Hong Kong Limited

(A-Alpha), a Hong Kong corporation, for research and development

services, to the extent that such payments were U.S. source

income.

     Respondent does not contend that any of the partnerships are

shams, nor that any adjustments are required under section 482.

The notice of deficiency provides that petitioner's failure to

withhold gave rise to the following deficiencies:

           Year                        Deficiency
           1976                        $189,300
           1977                         374,463
           1978                         639,555
           1979                         320,664
           1980                         321,300

     On a motion for summary judgment, the moving party must show

the absence of dispute as to any material fact and that a

decision may be rendered as a matter of law.        Rule 121(b);

Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986); Sundstrand

Corp. v. Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965

(7th Cir. 1994).   The facts will be viewed in the light most

favorable to the nonmoving party.      Elias v. Commissioner, 100

T.C. 510, 514 (1993); Naftel v. Commissioner, 85 T.C. 527, 529

(1985).   The party opposing the motion must set forth specific

facts showing there is a genuine issue for trial, and cannot rest

upon mere allegations or denials.   Rule 121(d); O'Neal v.
                                 - 3 -

Commissioner, 102 T.C. 666, 674 (1994).     A genuine factual issue

will be material only if its determination one way or the other

would affect the outcome.     Anderson v. Liberty Lobby Inc., 477

U.S. 242, 248 (1986).     Ultimately, if there exists any reasonable

doubt as to the facts at issue, the motion must be denied.

O'Neal v. Commissioner, supra at 674; Sundstrand Corp. v.

Commissioner, supra at 520.     We set forth a summary of facts

relevant to our discussion that do not appear to be in dispute;

the facts are stated solely for purposes of deciding the motion

and are not findings of fact for this case.     Fed. R. Civ. P.

52(a); Sundstrand Corp. v. Commissioner, supra at 520.

Background Information

     Beginning in 1972, petitioner researched and developed

inventions.     The inventions were placed into limited

partnerships.     The partnerships then paid A-Alpha to perform

research and development.     The Hong Kong corporation then

subcontracted all of its research and development contracts, in

varying proportions, to wholly owned U.S. and Hong Kong

corporations and to independent subcontractors.     Respondent

asserts that pursuant to section 881(a), of the amounts paid by

the limited partnerships, a flat 30 percent is due on that

portion of the funds which reentered the United States under a

subcontract.2    Further, respondent determined that petitioner, as

     2
         There is no tax treaty between the United States and Hong
                                                    (continued...)
                                   - 4 -

general partner of each limited partnership, was personally

liable for the withholding tax due because he was a withholding

agent under section 1442.      Sec. 1461.

     Each limited partnership was formed under the laws of a

State of the United States and operated using a calendar year.

Once an idea was selected and assigned to a limited partnership,

petitioner, acting as the general partner of each limited

partnership,3 negotiated a research and development contract with

A-Alpha, a Hong Kong limited liability company formed under the

laws of Hong Kong.       Capital was raised from investors by selling

limited partnerships interests, which represented 50 percent of

the limited partnerships.      The interests sold varied in amount

but were typically between $10,000 and $20,000.        Additionally,

each investor agreed to become personally liable for 125 percent

of the investor's cash investment.         Once the capital was raised,

the limited partnerships obtained loans from Wells Fargo Bank.

The total amount of capital raised ranged from $400,000 to

$800,000.    This amount was then paid (less attorney's fees and

other expenses) to A-Alpha.




     2
        (...continued)
Kong.
     3
        Petitioner contends that he was not the general partner
of certain of the limited partnerships formed in 1980. This is a
factual dispute, and we resolve it in favor of respondent, the
nonmoving party. Elias v. Commissioner, 100 T.C. 510, 514
(1993).
                                - 5 -

     Shortly after the formation of the limited partnerships,

those partnerships each granted an option to Engineering Systems

Corp. (ESC) for the purchase of all rights to the invention

involved, exercisable upon its becoming market-ready.     In

consideration of the option, ESC secured the loans of the limited

partnerships with time deposits made with Wells Fargo, and agreed

to pay the partnerships quarterly payments until the option was

exercised.    The quarterly payments for the option were equal to

the interest that became due on the loans.    The minimum exercise

price of the option was equal to the principal amount of the

loan.    Pursuant to a collateral agreement, the partnerships

agreed to pay interest and principal as it became due on the

loan,4 not to make any disbursements until the loan was

liquidated or the pledged assets were returned, and to cause the

pledged assets to be released as the partnerships received

royalties.

     During the years in issue, petitioner was the chairman5 of

the board of directors of A-Alpha, but at no time owned any stock

of A-Alpha.    The shareholders of A-Alpha were outside investors

whose interests were held by nominees, and whose identities were




     4
        The offering memorandum indicated that the option
agreement provided sufficient income to cover loan interest.
     5
        Chairmanship of a Hong Kong limited liability company is
the equivalent of being an executive officer of a U.S.
corporation.
                              - 6 -

allegedly unknown to petitioner.   A-Alpha was a holding company

which owned both U.S. and Hong Kong corporations.6

     In the United States, A-Alpha had direct and indirect

subsidiaries capable of performing research and development work,

ESC and Ferrite Manufacturing Co. (Ferrite).   ESC, Ferrite, or


     6
        Alphatronics Mfg. Ltd. (Alpha Mfg.), a Hong Kong
corporation, was a wholly owned subsidiary of A-Alphatronics (A-
Alpha). Petitioner was a director of Alpha Mfg. from Apr. 4,
1976. Alphanetics Co. Ltd. (Alphanet), a Hong Kong limited
liability company, was a wholly owned subsidiary of A-Alpha.
Petitioner was a director of Alphanet from Jan. 25, 1975. On
Mar. 31, 1981, Alphanet was sold to Atlas Indus. Ltd. (Atlas).
Alphanet had three subsidiaries, Alphanetics Mfg. Co. Ltd.
(Alphanet Co.), a Hong Kong limited liability corporation,
Alphanetics Mfg. (Alphanet Mfg.), a California corporation, and
Ferrite Mfg. Corp. (Ferrite), a California corporation.
Petitioner was a director of Alphanet Co., and a secretary of
Ferrite. Data Magnetics Ltd. (Data), a Hong Kong limited
liability company, was a wholly owned subsidiary of A-Alpha; on
Nov. 28, 1978, Hong Kong Shanghai Bank sold assets of Data to A-
Alpha. Ferromagnetics Corp. (Ferro), a Nevada corporation, was a
wholly owned subsidiary of Data acquired on Apr. 23, 1979. Data
Magnetics Corp. (Data Corp.), a California corporation, was a
wholly owned subsidiary of Data. Petitioner was Data Corp.'s
secretary. Administronics, Inc. (Admin), a California
corporation, was wholly owned by A-Alpha; it was never active.
Intermart International, Inc. (Intermart), a California
corporation, was wholly owned by Data. On June 28, 1979, it
changed its name to A-Alphatronics International, Inc. (A-Alpha
Intl.). Petitioner was a director for all relevant periods.
National Elec. Corp., a California corporation, was a wholly
owned subsidiary of A-Alpha, which was merged into Intermart on
Dec. 31, 1977. Atlas Indus. (Atlas) was a publicly traded Hong
Kong limited liability company. After reorganization, A-Alpha
owned 49.85 percent of Atlas. Petitioner was chairman of the
board of Atlas after 1980. Atlas Electronics International, Inc.
(Atlas Intl.), a California corporation, was a wholly owned
subsidiary of Atlas; it was formed on Apr., 19, 1980, and was
inactive during the years in issue. Atlas Elec. Corp. (Atlas
Elec.) was a wholly owned subsidiary of Atlas and was inactive in
the years in issue (no statements or allegations were made as to
where Atlas Elec. was incorporated).
                                - 7 -

their independent third-party subcontractors performed services

with respect to some of the inventions.    Engineering Systems

Corp. (ESC) was formed under the laws of California on April 4,

1974.    Although ESC was initially owned by petitioner, during the

years in issue it was a wholly owned subsidiary of A-Alpha.      ESC

received all of its revenue during the years in issue from A-

Alpha or A-Alpha's subsidiaries.    ESC billed A-Alpha at cost plus

5 percent.    Petitioner was the chairman of ESC's board of

directors.

     The limited partnerships reported income on the cash basis

of accounting using a calendar year.    A-Alpha and all of its

subsidiaries used a fiscal year ending March 31.    A-Alpha and its

Hong Kong subsidiaries used the Hong Kong completed contract

method of accounting, which recognized income and expenses in the

year in which the contractor concluded it had completed the

contract.7    ESC filed Federal income tax returns during the years

in issue and reported its income using an accrual method of

accounting.    ESC's financial statements indicate that it incurred

net losses of $1,586,451, $2,105,687, and $13,816 during the

years 1978 through 1980, respectively, and $1,074,613 for the

period beginning April 30, 1974, and ending March 31, 1977.

     A-Alpha subcontracted all of the research and development to

its Hong Kong and U.S. subsidiaries and to independent

     7
        Such determination was without regard to whether other
parties to the contract considered the contract fully performed.
                                - 8 -

contractors in contracts that were more than 1 year in duration.

The decision as to what portion of the overall contract would be

performed in the United States was always made after the end of

the first year of the limited partnership.    A-Alpha treated the

cash paid in the year of the contract as a deposit with it, to be

paid later for services to be performed by others.    Petitioner

expected that both A-Alpha and ESC would make a profit from their

respective activities.    In fact, they did not.

Discussion

     Respondent has asserted that the limited partnerships'

payments to A-Alpha for research and development are subject to

the 30-percent withholding tax under section 881(a), and that

petitioner, as general partner of the limited partnerships, is a

withholding agent for purposes of section 1442, and personally

liable under section 1461.    Because we conclude that the payments

by the limited partnerships are not subject to the 30-percent

withholding tax of section 881(a), we do not address whether

petitioner was a withholding agent.

     There are two taxing regimes that can apply to a foreign

taxpayer.    First, where a foreign corporation8 is engaged in a

U.S. trade or business, its effectively connected income from

that trade or business (ECI) is subject to taxation on a net


     8
        Although we refer to foreign corporations, we note that
there are similar provisions which apply to nonresident alien
individuals. See secs. 871-879, 1441.
                              - 9 -

basis at the same rates as other U.S. taxpayers.    Sec. 882(a)9.

Second, amounts received by a foreign corporation that are fixed

or determinable, annual or periodic (FDAP), from sources within

the United States (U.S. source), and not effectively connected

with the conduct of a U.S. trade or business (non-ECI) are

subject to a flat 30-percent tax.   Sec. 881(a).   FDAP includes

interest, dividends, rents, salaries, wages, premiums, annuities,

compensations, remunerations, and emoluments.   Sec. 881(a)(1).

     If a U.S. trade or business is a subsidiary of a foreign

corporation (FC), distributions by the subsidiary to the foreign

corporation, such as dividends or interest, generally are subject

to the 30-percent withholding tax imposed by section 881(a)(1).

Also, the Commissioner has broad powers to distribute, apportion,

or allocate gross income, deductions, credits, or allowances

between organizations controlled or owned by the same interests

if it is determined that such action is necessary to prevent the

evasion of tax or to clearly reflect income.    Sec. 482; Hospital

Corp. of America v. Commissioner, 81 T.C. 520, 592 (1983).     Thus

if a U.S. corporation transfers earnings and profits offshore

through improperly valued intercompany transactions, section 482

provides a means whereby the Commissioner may recharacterize the

     9
        Sec. 882(a) provides:
          (1) In General.--A foreign corporation engaged in trade
     or business within the United States during the taxable year
     shall be taxable as provided in section 11 or 1201(a) on its
     taxable income which is effectively connected with the
     conduct of a trade or business within the United States.
                              - 10 -

transfers to properly reflect income and prevent the avoidance of

the withholding tax.   See Central De Gas De Chihuahua, S.A. v.

Commissioner, 102 T.C. 515 (1994).

     If the U.S. trade or business is in the form of a branch of

a foreign corporation, earnings and profits of the U.S. trade or

business that are not reinvested in that trade or business are

subject to the 30-percent branch profits tax.    Sec. 884; see also

Kuntz & Peroni, U.S. International Taxation, par. C1.05[4][a]

(1995).   Although the mechanism of taxing the withdrawn earnings

and profits under section 884 is different from the withholding

tax of section 881(a), the result is the same; namely, that

transfer of profits to a foreign person is subject to 30-percent

withholding.   Section 884 was intended to provide parity between

foreign taxpayers doing business in the United States through

branches and domestic subsidiaries.    Tax Reform Act of 1986, Pub.

L. 99-514, sec. 1241(a), 100 Stat. 2576; Staff of Joint Comm. on

Taxation, General Explanation of the Tax Reform Act of 1986, at

1036, 1037 (J. Comm. Print 1987).

     Generally, if services are performed in the United States,

they give rise to U.S. source income, section 861(a)(3), and

services performed outside the United States give rise to foreign

source income, section 862(a)(3).    Income from services is

sourced where the services are performed, without regard to the

location of the payor, the residence of the taxpayer, the place

of contracting, or the place of payment.    Sec. 861(a)(3); Dillin
                               - 11 -

v. Commissioner, 56 T.C. 228, 244 (1971); sec. 1.861-4(a), Income

Tax Regs.

U.S. Source Income

     Petitioner insists that the amounts paid by the partnerships

are not U.S. source FDAP to A-Alpha.    We agree.   When the payment

for services was made by the limited partnerships, it was made to

A-Alpha, a Hong Kong limited liability corporation.    At the time

of payment, no part of it was U.S. source income of A-Alpha, for

no part of the contract had been performed in the United States.

Until A-Alpha performed some of the services in the United

States, there could not be any U.S. sourced income attributable

to A-Alpha.

     Respondent argues that the issue revolves around the

research and development activities performed in the United

States by ESC.    Accordingly, respondent contends that the U.S.

sourcing requirement of section 881(a) is satisfied.    We

disagree.    While it is true that amounts received in exchange for

services are sourced at the place of performance of those

services, such performance gives rise to income to the performer

of those services.    The performer of the services in this case

was ESC.    The fact that a lower tier corporation performs some

services in the United States is insufficient to support a

conclusion that its higher tier parent corporation also performs

services in the United States.    The two corporations are and
                               - 12 -

should be treated as separate persons unless one corporate form

is a sham.

     Furthermore, if one who performs services in the United

States later remits some of its gross income to a higher tier

corporation, such amounts lose their character as ECI, or

business income from the performance of the services, and

generally would be considered the investment income of the higher

tier parent corporation.10   Although it is true that ESC was a

wholly owned subsidiary of A-Alpha engaged in a U.S. trade or

business, it was doing business under its own name as a separate

and distinct entity.   The services performed by ESC did not give

rise to U.S. source business income of A-Alpha.   In order for A-

Alpha to be considered as having U.S. source income by virtue of

the performance of services, A-Alpha itself would have to perform

the services through agents or employees of its own.11

     Because respondent did not determine that any section 482

adjustments were necessary, respondent also did not determine

that ESC was an instrumentality of A-Alpha, or otherwise

controlled by A-Alpha in a way that would require us to disregard

the corporate form of ESC.   In the absence of evidence or an

     10
        Such investment income may be fixed or determinable,
annual or periodic, depending on the form of payment.
     11
        If A-Alpha did perform services, it is possible that it
could be considered as carrying on a trade or business in the
United States, and accordingly would not be taxed under sec.
881(a), but rather would fall under sec. 882(a), and be taxed on
its effectively connected income.
                             - 13 -

argument by respondent to the contrary, we treat all transactions

between ESC and A-Alpha as being conducted at arm's length.12

The relationship between A-Alpha and ESC is essentially no

different, for our purposes, than a contract between ESC and an

unrelated independent contractor.

     ESC was capable of making payments that constituted FDAP

taxable under section 881(a), but, in order for liability to

attach, there must have been a distribution of FDAP income by ESC

to A-Alpha, whether actual or deemed.   Respondent has not

determined that a reallocation or recharacterization of

intercompany transactions between ESC and A-Alpha is necessary

pursuant to section 482, and respondent does not allege that ESC

made any actual payments to A-Alpha.

     We conclude that A-Alpha did not receive any U.S. source

income from the U.S. limited partnerships, and therefore the

payments made by the various U.S. limited partnerships are not

subject to tax under section 881.

Fixed or Determinable Annual or Periodic Gains, Profits, or
Income

     Furthermore, even if a portion of the payments made by the

limited partnerships were U.S. source, it was not FDAP because it

was unascertainable during the year of payment what portion of


     12
        ESC billed A-Alpha for the work it performed at cost
plus 5 percent. If this was below fair market value for the type
of services performed, an avenue of attack by respondent is sec.
482.
                              - 14 -

the contract would be performed in the United States.    Respondent

argues that under the regulations, income is fixed when it is to

be paid in amounts definitely predetermined, and determinable

whenever there is a basis of calculation by which the amount may

be ascertained.   Secs. 1.1441-2(a)(1) and (2), Income Tax Regs;

see also sec. 1.881-2(b), Income Tax Regs.   The decision here to

allocate the contract for research and development was

consistently made by A-Alpha during a tax year of the limited

partnerships that was later than the year of payment by the

limited partnerships.

     Respondent argues that in instances like the present case

where it is not yet determinable what portion of a payment is

subject to withholding, the regulations provide that the

withholding agent should withhold on the entire amount, and the

payee can then apply for a refund.13   Specifically, section

1.1441-3(d), Income Tax Regs., provides that where the

withholding agent does not know the amount of recognized gain, he

is required to deduct and withhold an amount sufficient to ensure

that not less than 30 percent of the recognized gain is taxed.

This treatment is limited to amounts described in section 1.1441-

2(b)(2), Income Tax Regs, which enumerates certain income items

subject to the 30-percent withholding.   None of the categories of


     13
        This argument is at odds with respondent's argument that
withholding was only required in the portion of the contract
performed in the United States.
                             - 15 -

income enumerated therein apply to the payments at issue.14

Respondent's argument that withholding was due on the total must

fail.

     In light of these conclusions, we do not reach whether

petitioner was a withholding agent for purposes of section 1442.

Because we decide the law as we do, there are no facts which, if

proved at trial, would alter our result.   Accordingly,

petitioner's motion for summary judgment as supplemented will be

granted.

                                   An appropriate order and

                              decision will be entered.




        14
        Those income items are gains described in sec. 402(a)(2)
relating to distributions from employee trusts; sec. 403(a)(2)
relating to treatment of certain employee annuities; sec. 631(b)
or (c) relating to treatment of gain on the disposal of timber,
coal, or domestic iron ore with a retained economic interest;
gains relating to contingent payments from the sale or exchange
of patents, copyrights, and similar intangible property. Sec.
1.1441-2(b)(2), Income Tax Regs.
