Chang Hsiao Liang v. Commissioner

Chang Hsiao Liang, Petitioner, v. Commissioner of Internal Revenue, Respondent Chang Hsiao Liang v. Commissioner Docket No. 43978 United States Tax Court 23 T.C. 1040; 1955 U.S. Tax Ct. LEXIS 223; March 18, 1955, Filed *223 Decision will be entered for the petitioner. Petitioner, a nonresident alien whose securities were managed primarily for investment purposes by a resident commission agent, held, on facts, not subject to tax on capital gains as not being engaged in a trade or business within the United States under section 211 (b), Internal Revenue Code of 1939. D. Nelson Adams, Esq., and Frank H. Medinger, Esq., for the petitioner. Arthur L. Nims, Esq., for the respondent. Opper, Judge. OPPER *1040 Respondent determined a deficiency in petitioner's income taxes in the amount of $ 41,267.73 for the year 1946. In an amended answer, respondent asserted an increased deficiency for that year in the amount of $ 4,024.17. The issue is whether petitioner, a nonresident alien, was engaged in a trade or business within the United*224 States during the year in controversy as a result of his security transactions through a resident agent so as to permit taxation of his income therefrom under section 211 (b) of the Internal Revenue Code of 1939. If that question is answered affirmatively, it will follow that petitioner omitted from his gross income for the year 1946 a properly includible amount in excess of 25 per cent of the gross income reported on his return for that year so as to permit the application of the 5-year statute of limitations under section 275 (c) of the 1939 Code. *1041 FINDINGS OF FACT. Some of the facts have been stipulated and are found accordingly. Petitioner is a nonresident alien individual. He was not present in the United States at any time during the year in controversy. He filed his nonresident-alien income tax return for that year with the collector of internal revenue for the district of Maryland on or about June 15, 1947. The deficiency notice herein was mailed to petitioner on June 13, 1952. Sometime in 1928, petitioner became acquainted with Lamont M. Cochran, a United States citizen, who was manager of the Mukden, Manchuria, branch of the National City Bank of New York, hereinafter*225 sometimes called National City. At that time, petitioner was military governor of the three eastern provinces of Manchuria. He devoted his full time to military activities and had no other occupation from 1928 through 1946. Cochran was trying to get new business for the bank in 1928 and he approached petitioner with a view to obtaining a securities account from him. As a result of Cochran's efforts petitioner opened a securities account with the main office of National City. When the Japanese began their military action against the Chinese in Manchuria in 1931, Cochran believed that the Far East was no longer a desirable place in which to live. He then tried to make an arrangement with petitioner whereby Cochran would return to the United States and supervise petitioner's securities. On February 1, 1932, petitioner and Cochran entered into the following agreement as drafted by Cochran: This agreement is made this first day of February 1932 between Chang Hsiao Liang of Peiping, China and L. M. Cochran of Moukden, Manchuria. L. M. Cochran undertakes to supervise and care for the investments of Chang Hsiao Liang in the United States of America or elsewhere. In consideration Chang*226 Hsiao Liang binds himself to pay L. M. Cochran U. S. dollars fifteen hundred (say U. S. $ 1500.00) per month as salary and allowance for his services, together with a commission amounting to one percent of the profit, to be calculated at two year intervals. This agreement to remain in force for a period of ten years after which it may be cancelled on six months notice from either party. Cochran returned to the United States in April 1932 and commenced the task of managing petitioner's investments in this country. He continued to function in this capacity throughout the period 1932 to 1946, inclusive. Petitioner originally transmitted $ 3,000,000 in cash from Mukden to the National City main office to be invested in this country. Certain additional amounts were added between 1928 and 1932, but no additions were made thereafter. Petitioner's investments were managed by Cochran in 1946 through a custodian account maintained at the Guaranty Trust Company of *1042 New York City, hereinafter sometimes called Guaranty Trust. The agreement with Guaranty Trust was dated June 30, 1938, and was in force from that date through 1946. Under its terms, Guaranty Trust bought and sold securities*227 upon directions from Cochran. He would usually send a telegram at night which would be received before the opening of the market in the morning and would be executed at the opening prices through brokers of the bank's own choosing. Cochran performed no similar services for any other person in 1946, and had no other occupation aside from supervising petitioner's account. He bought and sold securities through no agency other than the Guaranty Trust account in 1946. Cochran exercised sole discretion as to the management of the account, including decisions as to the items and times of purchase and sale and the exercising of proxies. Securities owned by petitioner on which there was a liability on his part were registered in the name of Lamont M. Cochran, pursuant to the custody agreement. The custody agreement was signed on behalf of petitioner by Cochran as agent. Petitioner had capital gain income in 1946, resulting from his security transactions and capital adjustments, as follows: Amount taken Total amount into account Long-term gain $ 145,228.45 Long-term loss 16,823.70 Net $ 128,404.75 $ 64,202.37 Short-term gain $ 15,564.19 Short-term loss 2,370.10 $ 13,194.09 13,194.09 Net capital gain $ 141,598.84 $ 77,396.46 *228 Petitioner reported no capital gain income on his 1946 return. The activity in petitioner's account for the taxable year 1946 and for the 6 preceding years is summarized as follows: Cash and Average Gross income securities (at holding (exclusive of Year market) in period Net recognized capital gains Rate of account on of capital and losses), return January 1 securities gain (or loss) i.e., dividends on principal sold and interest Years Per cent 1940 1 $ 1,240,166.75 2.5 ($ 20,015.25) $ 51,647.19 4.2 1941 1 950,467.37 1.9 (4,817.65) 57,990.60 6.1 1942 1 809,202.01 3.5 (6,440.72) 55,813.93 6.9 [1943] 863,801.62 3.8 (38,854.73) 68,704.17 8.0 [1944] 1,189,411.28 3.3 4,259.13 75,902.67 6.4 [1945] 1,573,907.69 3.3 25,658.80 98,104.90 6.2 [1946] 2,316,726.27 5.8 77,396.46 95,073.42 4.1 *1043 Total sales in the amount of $ 442,886.63 were consummated by Cochran in 1946. The gross gain less gross losses from account activity in that year totaled $ 141,598.84. Of that amount, more than $ 132,000 was derived from the sale of*229 securities held for more than 2 years; more than $ 93,000 from securities held for more than 3 years; and more than $ 60,000 from securities held for more than 5 years. During the years 1940 through 1945, the major portion of gains and losses were long-term in nature, and the dollar amount of sales and purchases in each year was small in relation to the market value of the portfolio. In 1946, petitioner's funds were largely invested in stock rather than bonds in order to obtain a higher yield on the investments. This required closer supervision and more changing in the account as conditions changed. The agent's objectives in managing the account were to obtain a large income to meet heavy drawings and at the same time to protect and preserve the principal. The securities were of an investment character and were carefully diversified both as to type and as to industry. The agent never dealt in commodities; never purchased securities on margin; never borrowed money to manage the account; never acquired any hedges; never made short sales; and never purchased any "puts" or "calls." The 1 per cent commission received by the agent was based on all income earned by the account, regardless*230 of source, including both capital gain and dividend and interest income. The greater activity in the account in the 2 years 1940 and 1946 was attributable to natural shifts resulting from the fall of France with the consequent threat of impending war for the United States and from the shift from wartime to peacetime industries in the first postwar year, respectively. The distinction between an investment account and a trading account is that in the former, securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market. In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis. Petitioner reported gross income on his 1946 return in the total amount of $ 68,050.59, representing dividends and interest. The amount reported does not include $ 4,250 which petitioner received in 1946 as a cash distribution in connection with the exchange of 500 shares of American Woolen 7 per cent preferred stock for 750 shares of American Woolen convertible*231 4 per cent preferred stock, and which amount is stipulated to be taxable as ordinary dividend income. Petitioner was held in "protective custody" by Generalissimo Chiang Kai-shek throughout the year 1946. He was transferred from Kweiyang, China, to the island of Formosa sometime in that year. Although *1044 petitioner sent occasional letters to Cochran through people from Formosa, no direct communication was received by Cochran from petitioner in 1946. During 1946, petitioner maintained a checking account at National City. The sum of $ 4,000 was charged to the Guaranty Trust account on the first day of each month in that year, and credited to the National City account. Wartime restrictions against sending currency out of the country had been lifted by 1946. During 1946, petitioner's wife, two sons, and a daughter were living in the United States. Part of the monthly deposits of $ 4,000 were used for their support. Petitioner was not engaged in a trade or business in the United States during 1946. OPINION. Petitioner, a nonresident alien, was not present in this country in 1946 nor, apparently, at any other time after he entered into the agency agreement in 1932. He left*232 the management of his considerable account entirely to the discretion of his agent. The latter invested petitioner's funds in stocks and securities. He never acquired any hedges; never made short sales; and never purchased "puts" or "calls." His commission in excess of a fixed salary was based on total earnings of the account, regardless of source. Purchase and sale activity in the account during 1946, the year in controversy, and during 1940, which far exceeded such activity in other years, is adequately explained by transitional changes in the industries represented by the securities immediately before and after American participation in World War II, when increased trading activity was not unusual in the routine conservation and management of investment portfolios. And, in spite of increased activity, even during the year in controversy the average holding period of the securities sold was 5.8 years. More than 90 per cent of the gross gain was derived from the sale of securities held for more than 2 years; and more than 40 per cent of the gross gain was realized from the sale of securities held for more than 5 years. The absence of frequent short-term turnover in petitioner's*233 portfolio negatives the conclusion that these securities were sold as part of a trading operation rather than as investment activity. Section 211 (b) of the Internal Revenue Code of 19391 was intended to exempt capital gains realized by nonresident aliens from transactions *1045 in commodities, stocks, or securities effected through a resident broker or commission agent, unless such transactions constitute the carrying on of a trade or business 2 rather than mere incidents of a personal investment account. *234 Whether activities undertaken in connection with investments are sufficiently extensive to constitute a trade or business is a question to be decided on the particular facts. Higgins v. Commissioner, 312 U.S. 212. In Fernand C. A. Adda, 10 T. C. 273, affirmed per curiam (C. A. 4) 171 F. 2d 457, certiorari denied 336 U.S. 952, extensive transactions in commodities which do not pay dividends and could have resulted in profit only by means of the gains on the purchases and sales were found to constitute a trade or business. For similar reasons Commissioner v. Nubar, (C. A. 4) 185 F. 2d 584, reversing 13 T. C. 566, certiorari denied 341 U.S. 925, held that transactions in commodities and securities where the taxpayer was himself present in the United States throughout the period were sufficient to constitute the conduct of a trade or business. The present situation is quite different. Petitioner never having been present in the United States, it is only through the activity of*235 his agent that he could be held to have conducted a business. For the solution of this problem we look not solely to the year in controversy but to the entire agency and particularly to the 7 years shown by the record. These figures appearing in our findings satisfy us that the primary, if not the sole objective, was that of an investment account established to provide a reliable source of income. In fact in 4 of the 7 years the capital transactions resulted in losses rather than gains and only in the year for which respondent has determined the deficiency were the gains of any considerable consequence. Granting that Congress "did not intend to permit a nonresident alien to establish an agent in the United States to effect transactions for his account and escape taxation of the profits" 3 where such activity is in the nature of a trade or business, we are satisfied that here the agent did no more than was required to preserve an investment account for his principal. See Higgins v. Commissioner, supra;Kane v. Commissioner, (C. A. 2) 100 F. 2d 382. Cf. Commissioner v. Nubar, supra.*236 We have found as a fact that petitioner was not engaged in a trade or business in this country during the year 1946. Consequently, respondent's determination was, in our view, erroneous. *1046 The applicability of the extended 5-year statute of limitations under section 275 (c) of the 1939 Code 4 to the year in controversy and the matter of an increased deficiency for that year as to which respondent has the burden are both dependent upon the disposition of the primary question. As to these issues, therefore, respondent's action must also be disapproved. *237 Decision will be entered for the petitioner. Footnotes 1. Amount of cash in account not available for these years.↩ 1. SEC. 211. TAX ON NONRESIDENT ALIEN INDIVIDUALS. (b) United States Business or Office. -- A nonresident alien individual engaged in trade or business in the United States shall be taxable without regard to the provisions of subsection (a). As used in this section, * * * the phrase "engaged in trade or business within the United States" * * * does not include the effecting, through a resident broker, commission agent, or custodian, of transactions in the United States in commodities * * * or in stocks or securities.↩ 2. H. Rept. No. 2475, 74th Cong., 2d sess. (1936), p. 9; S. Rept. No. 2156, 74th Cong., 2d sess. (1936), p. 21.↩ 3. Fernand C. A. Adda, supra↩, at 277. 4. SEC. 275. PERIOD OF LIMITATION UPON ASSESSMENT AND COLLECTION. Except as provided in section 276 -- (c) Omission from Gross Income. -- If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.↩