## Facts

- Garlock, Inc., a U.S. manufacturer, formed Garlock, S.A., a Panamanian subsidiary in 1958 to market its products abroad; through 1962 Garlock owned 100% of S.A.’s single class of common stock.
- After enactment of Subpart F in 1962, Garlock proposed restructuring S.A.’s capital and voting rights to prevent S.A. from qualifying as a controlled foreign corporation (CFC) under I.R.C. § 957(a).
- S.A. issued $100,000 of callable, cumulative preferred stock (1,000 shares at $100 par) carrying one vote per share and an 8% cumulative dividend.
- A majority of the preferred shares were placed with two foreign investors identified as willing to vote with Garlock; the investors used the same law firm as Garlock.
- The preferred shareholders’ economic return was limited relative to the voting rights they received, suggesting that voting rights did not reflect genuine independent control.
- The Commissioner determined deficiencies for Garlock’s 1964 and 1965 tax years, treating S.A. as a CFC and requiring Garlock to include its pro rata share of S.A.’s Subpart F income under § 951.
- The Tax Court sustained the deficiencies, and Garlock appealed.

## Issues

1. Whether S.A. was a CFC under I.R.C. § 957(a) for 1964 and 1965 when, after recapitalization, foreign preferred shareholders held formal majority voting rights, in light of Treas. Reg. § 1.957-1(b)(2) (disregarding arrangements where U.S. shareholders retain voting power in reality).
2. Whether I.R.C. § 951 is unconstitutional insofar as it requires current inclusion of certain undistributed foreign corporate income to U.S. shareholders.

## Decision

- The Second Circuit affirmed the Tax Court.
- The court held S.A. was a CFC during 1964 and 1965 because the purported transfer of voting power to foreign preferred shareholders was illusory and Garlock effectively retained control.
- The court upheld Treas. Reg. § 1.957-1(b)(2) as a reasonable interpretation implementing § 957(a).
- The court rejected Garlock’s constitutional challenge and sustained § 951’s current-inclusion regime as within Congress’s taxing power.

## Legal Principles

- For CFC status under § 957(a), “voting power” is determined by practical, real-world control, not solely by formal share voting allocations.
- Under Treas. Reg. § 1.957-1(b)(2), arrangements shifting formal voting rights away from U.S. shareholders may be disregarded if voting power is retained in reality; mere ownership of stock entitled to vote does not necessarily establish actual voting power for § 957 purposes.
- Evidence that supports disregarding formal voting rights includes a tax-avoidance purpose, disproportion between voting rights and economic interest, and indications that purported non-U.S. voters do not exercise voting rights independently.
- Section 951’s attribution of certain undistributed foreign income to U.S. shareholders of a CFC is constitutionally permissible.

## Conclusion

The court treated Garlock’s recapitalization as a form-only shift of voting rights and held that S.A. remained a controlled foreign corporation, requiring Garlock’s current inclusion of Subpart F income under § 951; it also upheld the validity of the implementing regulation and rejected the constitutional challenge to Subpart F.


Garlock, Inc. v. Commissioner of Internal Revenue, 489 F.2d 197 (2d Cir. 1973)