## Facts

- SDI Netherlands B.V., a Netherlands corporation in a commonly controlled multinational group, held a worldwide software license from SDI Bermuda Ltd., a Bermuda corporation, under a 1986 license agreement.
- SDI Netherlands separately sublicensed U.S. rights to SDI USA, Inc., a U.S. corporation, for royalties and also licensed to other parties.
- SDI Netherlands paid SDI Bermuda specified percentages of the royalties it received from its licensees as consideration under the Bermuda license agreement.
- The royalties SDI Netherlands received from SDI USA were U.S.-source royalties; SDI Netherlands treated that income as exempt from U.S. tax under the U.S.–Netherlands income tax treaty.
- The Commissioner determined SDI Netherlands was liable for withholding taxes under I.R.C. §§ 1441–1442 on the royalties it paid to SDI Bermuda for 1987–1990, plus additions to tax under § 6651(a)(1) for failure to file Forms 1042.
- The parties stipulated all facts; the Tax Court addressed a single disputed question: withholding liability (and related additions to tax) on payments from SDI Netherlands to SDI Bermuda.

## Issues

1. Whether royalties paid by SDI Netherlands to SDI Bermuda were “income received from sources within the United States by” SDI Bermuda under I.R.C. § 881(a) because the payments were economically traceable to U.S.-source royalties paid by SDI USA to SDI Netherlands.
2. Whether, on that theory, SDI Netherlands was required to withhold U.S. tax under I.R.C. §§ 1441(a) and 1442(a) and was liable for § 6651(a)(1) additions for failing to file Forms 1042.

## Decision

- The Tax Court held SDI Netherlands was not liable for U.S. withholding tax on the royalties it paid to SDI Bermuda.
- The court found the Bermuda license and the U.S. sublicense were separate and distinct agreements; U.S.-source character did not carry over from SDI USA’s payments to SDI Netherlands into SDI Netherlands’ payments to SDI Bermuda.
- Because SDI Bermuda did not receive U.S.-source income within the meaning of § 881(a), there was no underlying U.S. tax to be collected by withholding under §§ 1441–1442.
- The related § 6651(a)(1) additions to tax for failure to file Forms 1042 were not sustained.

## Legal Principles

- Withholding under I.R.C. §§ 1441–1442 depends on whether the payment to the foreign payee is U.S.-source FDAP income that is taxable to the payee under I.R.C. § 881(a).
- For purposes of § 881(a), the inquiry focuses on the legal recipient and source of the income under the operative agreements, not on an economic tracing of funds through related entities.
- When a foreign intermediary holds substantive licensed rights and separately sublicenses those rights, royalties paid upstream under a distinct license agreement do not automatically retain the U.S.-source character of downstream royalties.

## Conclusion

The Tax Court rejected the Commissioner’s attempt to impose withholding by tracing U.S.-source sublicense royalties through a Netherlands licensor to a Bermuda affiliate, holding that separate license contracts controlled the source analysis and eliminated withholding and related filing-penalty liability.


SDI Netherlands B.V. v. Commissioner, 107 T.C. 161 (1996)