Taxation

• Author: International Law Group

The petitioners in this case are ten individuals and one Connecticut corporation founded by David Deitsch in 1960. The individuals belong to the Deitsch family. Petitioners own the company which manufactures laminated materials for the production of upholstery. Petitioners had been receiving two sorts of payments from an Israeli corporation. First, there were payments made directly to petitioners on which they paid taxes to the Israeli Government. The second type involved payments made to a partnership and reported by certain petitioners as their distributive shares of partnership income.

In 1974, David Deitsch established a company in Israel to manufacture flocked fabrics for the production of drapery and upholstery, called Flocktex Industries, Ltd., also owned by the petitioners. Beginning in 1987, Flocktex began making substantial payments to "Flocktex shareholders," in some instances as much as $2.35 million. Through withholding, the recipients paid income taxes to the State of Israel which certified the payments as "commission fees." Flocktex itself classified the payments as "selling expenses" paid as "special commissions."

The individual petitioners reported the special commissions on their U.S. income tax returns as "other income," not as dividends on Schedule B. They claimed foreign tax credits on their U.S. tax returns for the Israeli taxes that Flocktex had paid. The Internal Revenue Service disagreed.

In this Tax Court action, the petitioners argued that U.S. tax law characterized both special commissions paid by Flocktex as dividend income from a foreign source. In their view, the Israeli labels for reporting purposes were not conclusive. Furthermore, petitioners argued that dividend treatment was appropriate because the recipients rendered no services and because the large size of the payments made it unreasonable to view them as compensation.

On the other hand, the IRS asserted that petitioners' characterizations impermissibly sought to reduce U.S. income taxes through improper claiming of foreign tax credits and assigning of income among entities. In its view, the special commissions represented compensation for services performed in the U.S.

The U.S. Tax Court concludes that the payments to the petitioners were not foreign source income for purposes of calculating the credit for foreign taxes...