The U.S. Tax Court recently held that a foreign partner’s gain on the sale of its interest in a U.S. partnership was not effectively connected income subject to U.S. tax. In reaching its conclusion in Grecian Magnesite Mining v. Commissioner, the court rejected a 1991 IRS Revenue Ruling.
The case is favorable for foreign investors in U.S. funds and other U.S. businesses classified as partnerships.
International U.S. Tax Primer
U.S. citizens and resident aliens are generally subject to U.S. tax on their worldwide income. Non-U.S. persons, including non-resident aliens and foreign corporations, are generally subject to U.S. tax on:
1. Effectively connected income — income that’s “effectively connected” with a U.S. trade or business in which the taxpayer is engaged, and
2. U.S.-source Fixed or Determinable Annual or Periodical income (FDAP income), such as dividends, certain interest, rent, royalties, and compensation.
Effectively connected income is taxed on a net basis at graduated rates. FDAP income is generally taxed on a gross basis at a flat 30% rate (unless a lower rate applies pursuant to a tax treaty). Non-U.S. taxpayers are exempt from tax on capital gains from the sale of U.S. securities and other capital assets, unless such gains are effectively connected income. Foreign owners of U.S. real property interests are also deemed to be engaged in the U.S. trade or business of owning real estate if they own U.S. real property directly or through an entity.
In Revenue Ruling 91-32, the IRS adopted the position that non-U.S. persons owning an interest in a partnership engaged in a U.S. trade or business are subject to tax when they sell their partnership interest. The IRS reached this conclusion based on the “aggregate theory”, which views a partnership as an aggregation of its partners rather than as a discrete legal entity. Therefore, a partner’s sale of its partnership interest is treated as a disposition of its interest in the partnership’s assets.
Grecian Magnesite Mining (GMM), a Greek mining corporation, owned a minority interest in Premier Chemicals, a Delaware LLC classified as a partnership for tax purposes and engaged in mining activities in the U.S. Other than its interest in Premier, GMM had no U.S. offices, employees, or business operations.
In 2008, Premier agreed to redeem GMM’s interest in exchange for two cash payments, resulting in a gain to GMM of approximately $6.2 million. Although GMM had filed U.S. tax returns reporting its distributive share of Premier’s income, gain, loss, and deductions and credits, it did not report the gain from the redemption of its ownership interest.
On audit, the IRS determined that GMM should have recognized the entire amount as U.S.-source capital gain. GMM conceded that $2.2 million of the gain was attributable to U.S. real property interests and, therefore, was taxable. GMM disputed the taxability of the remaining $4 million.
Aggregate Theory and Office Rule
To decide the case, the tax court considered and rejected two IRS arguments.
First, the IRS urged the court to adopt the “aggregate theory”, which would treat GMM’s sale of its LLC interest as a sale of its interest in the LLC’s assets. In this instance, because Premier used those assets in its U.S. trade or business, the gain would be considered ECI.
In disagreeing with this theory, the court observed that the tax code generally follows the “entity theory” which treats the sale of a partnership interest as the sale of a single, indivisible capital asset. The existence of exceptions to the entity theory in the Internal Revenue Code for U.S. real property interests and certain “hot assets,” such as appreciated inventory and unrealized receivables, prove this rule. If Congress had intended the aggregate theory to apply to all sales of partnership interests, those exceptions would have been superfluous.
Having determined GMM’s gain was from the sale of its partnership interest rather than from the partnership’s underlying assets, the tax court held it was foreign-source income and not effectively connected income. Generally, gain from the sale of personal property is sourced based on the residency of the seller.
The IRS countered that the gain should be treated as U.S. source effectively connected income under the “U.S. office rule.” Under such rule, if a non-U.S. taxpayer maintains an office or other fixed place of business in the U.S., income from the sale of personal property attributable to that fixed place of business is sourced in the U.S. While the court agreed that Premier’s U.S. office was deemed to be GMM’s fixed place of business by virtue of its LLC interest, it rejected the argument that GMM’s gain was attributable to that office. Such an argument would require that the office was a “material factor” in the production of the gain and the office carried out the activities producing the gain in the ordinary course of business.
The IRS argued that the office was a material factor as it was material to the deemed sale of GMM’s share of the LLC’s assets. Alternatively, the IRS said it was material to the increased value of Premier that GMM realized in the redemption. The first argument failed because the court had already held that GMM sold its LLC interest and not its share of the LLC’s assets. The court also rejected the second argument, explaining that it “conflates the ongoing value of a business operation with gain from the sale of an interest in that business.” In addition, the redemption was a “one-time, extraordinary event”, not a purchase in the ordinary course of business.
The tax court’s decision is a victory for foreign investors in U.S. partnerships, but the implications of the decision are not yet clear. The IRS may appeal the decision, issue a non-acquiescence and continue to follow Rev. Rul. 91-32, or it may develop new theories for taxation of such gains. It is also possible that the IRS and Treasury Department will issue regulations adopting the reasoning of Rev. Rul. 91-32, or that Congress will pass legislation codifying the ruling.
In the meantime, foreign investors who have already paid U.S. tax on gains from the disposition of partnership interests should consider filing protective refund claims before the statute of limitations expires.
If you feel this tax court decision has relevance to your operations, please contact your Untracht Early representative.