In a recent ruling, the US Tax Court rejected the IRS’s traditional approach to determining effectively connected income (ECI) on the disposition of partnership interest involving a non-US partner. In the case of Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 T.C. No. 3, the court rejected the IRS’s approach for determining whether income from the disposition of a partnership interest is effectively connected with a US trade or business. Essentially, the Tax Court ruled that gains from sale or redemption of partnership interests by foreign partners are not subject to U.S. income tax, a very favorable ruling to taxpayers, particularly for foreign investors in U.S. entities.
Under IRS Revenue Ruling 91-32, which has been in effect since 1991, the IRS takes the approach that a non-U.S. partner’s gain on the sale of an interest in a partnership is treated as ECI to the extent such gain is attributable to the partnership’s assets held for use in the partnership’s US trade or business.
In this ruling, the court refused to defer to the IRS’s approach to the issue in Rev. Rul. 91-32, stating that 25 year old revenue rule “lacks the power to persuade” and criticizing its discussion of the partnership rules as “cursory.”
Background and Relevant Details of the Case
In 2001, Grecian Magnesite Mining (GMM), a Greek corporation, purchased an interest in Premier Chemicals, LLC (Premier), a US limited liability company. In 2008, Premier redeemed Grecian’s interest, with payments to be made over two years, resulting in approximately $6.2 million of total gain to Grecian. GMM did not report the gain to the IRS as ECI, and thus, it took the position that the gain from the redemption of its partnership interest was not taxable in the U.S. The Court affirmed GMM’s tax position.
GMM correctly argued that a sale or redemption of partnership interest was a sale of a single capital asset under IRC Section 741, similar or equivalent to a sale of a corporation’s stock. The source of capital gains, or losses is determined by the seller’s residence. If the seller is foreign the source of the capital gain or loss is foreign sourced. GMM was a foreign corporation so the source of the income was foreign. GMM further argued that it was not in the business of selling partnership interests.
The Court agreed, it stated that “the gain was not realized in the ordinary course of business conducted through the U.S. office or other place of business, because the redemption transaction was not part of the Partnership’s ordinary business, but rather a one-time, extraordinary event.”
The Court rejected the aggregate theory on several grounds. It noted that in the case of a sale of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in Section 751 (relating to unrealized receivables and inventory items). If “look through” treatment or aggregate theory were the general norm, then Section 751 would be unnecessary.
The same would be said with respect to Section 897(g) which provides in part, that amounts received by a foreign person in exchange for a partnership interest “shall, to the extent attributable to United States real property interests, be considered an amount received from the sale or exchange in the United States of such property.” The Tax Court noted that Congress explicitly carved out a few exceptions to IRC Section 741 that, when applicable, require look-through treatment. “If Congress had intended IRC Section 741 to be interpreted as a look through provision, these exceptions in Sections 751 and 897(g) would be superfluous.”
What Is the Impact of the Ruling?
Non-US persons generally are subject to US tax on two types of income: ECI or “fixed, determinable, annual or periodical” income (“FDAP income”). Any income determined to be ECI, received by a non-US person, is subject to US tax on a net income basis, and said non-US person has to file a US income tax return.
For the most part, the IRS based its position – that income received from the disposition of this partnership was in fact, ECI – by taking an “aggregate theory” approach allowed under Rev. Rul. 91-32 that holds the gain realized by a foreign partner on the sale or disposition of its interest in a partnership engaged in a trade or business in the United States should be analyzed asset by asset, and that, to the extent there would be ECI with respect to asset sales, the selling partner’s pro rata share of such gain should be treated as ECI.
On the contrary, in their rejection, the court took an “entity theory” approach, concluding that the disputed portion of the redemption proceeds should be treated as gain from the sale or exchange of “a singular capital asset.” The court then turned to the international tax rules to determine whether that gain was taxable, specifically as US-source ECI, and determined that it would not defer to the IRS’s approach in Rev. Rul. 91-32, which “is not simply an interpretation of the IRS’s own ambiguous regulations, and . . . lacks the power to persuade.”
Since its inception, Rev. Rul. 91-32 has been controversial. This ruling may not be the last word on the matter, as it is likely that the IRS will appeal the court’s decision.
If not overturned on appeal and not reversed by an act of Congress or the inception of new rules and regulations by the Treasury Department, the decision could dramatically change the tax structuring considerations for non-US persons investing in a partnership conducting a US business.
How MBAF Can Help
In light of the ruling, if you are operating, or considering creating, or dissolving, a partnership involving non-US persons, now would be a good time to analyze the structure of your arrangements, to make sure they are designed with the best interests of legally realizing gains, while simultaneously minimizing tax obligations.
Compliance with, and understanding of, IRS Revenue Ruling 91-32 for tax purposes can be complex. If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Tax and Accounting specialists, or call us at 1-800-239-1474.