Foreign Nationals Investing in U.S. Partnerships May be Entitled to Tax-favorable Treatment

On July 13, 2017, the United States Tax Court (the “Tax Court”) issued a very important opinion, that of Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner 149 T.C. 3 (2017).  In this case, the Tax Court rejected the Internal Revenue Service’s (the “IRS’s”) approach for determining whether income from the disposition of a partnership interest is effectively connected with the conduct of a United States (“U.S.”) trade or business.  That approach has been in place for decades under the IRS’s seminal Revenue Ruling 91-32, 1991-1 C.B. 107.  The facts of the case were as follows.

In 2001, the taxpayer purchased an interest in a U.S. limited liability company (the “LLC”) engaged in a U.S. trade or business and taxed as a partnership.  In 2008, the taxpayer agreed to have its interest redeemed by the LLC and received two liquidating payments, one in 2008 and one in 2009, with a transfer effective date of December 31, 2008.  Following the redemption, the taxpayer filed a 2008 IRS Form 1120-F, but did not report any gain from that redemption.  The taxpayer also did not file a return for the 2009 taxable year.

The IRS asserted that the taxpayer had U.S. source gain in both 2008 and 2009 that was effectively connected with the conduct of a U.S. trade or business.  The IRS based its position on the aforementioned ruling, which adopted an “aggregate theory” approach in holding that the gain realized by a foreign partner on the sale or disposition of its in interest in a partnership engaged in a trade or business through a fixed place of business in the U.S. should be analyzed asset by asset, and that, to the extent there would be effectively connected income (“ECI”) with respect to the asset sales, the selling partner’s pro rata share of such should be treated as ECI.

The Tax Court first stated that pursuant to §736(b)(1) of the Internal Revenue Code of 1986, as amended (the “Code”), payments made in redemption of the taxpayer’s interest should be considered a distribution and that, pursuant to Code §731(a), any gain or loss should be considered as gain or loss from the sale or exchange of the partnership interest.  Code §741 provides the general rule that, in the case of a sale or exchange of an interest in a partnership, gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset.  Based on the text and structure of the Code’s Subchapter K, the Tax Court adopted an “entity theory,” concluding that the redemption proceeds should be treated as gain from the sale or exchange of a “singular capital asset.”

The Tax Court then stated that with respect to whether that gain should be taxable as ECI, the IRS’s approach in Revenue Ruling 91-32 “lacks the power to persuade.”  Proceeding with its analysis, the Tax Court looked to Code §865(e)(2)(A), which states that if a nonresident maintains an office or other fixed place of business in the U.S., then the income from any sale of personal property attributable to such office or other fixed place of business shall be sourced to the U.S.  Code §865(e)(3) further states that the principles of Code §864(c)(5) apply in determining whether a taxpayer has an office or fixed place of business and whether a sale is attributable to the same.  Under Code §864(c)(5)(B), income, gain, or loss is attributable to a U.S. office only if the U.S. office is “a material factor in the production of such income” and the U.S. office “regularly carries on activities of the type from which such income, gain, or loss is derived.”

The IRS argued that the taxpayer’s gain was attributable to the U.S. LLC’s office, which was responsible for the increased value in the taxpayer’s partnership interest.  However, the Tax Court concluded that in order for the disputed gain to be attributable to a U.S. office, that office’s activities “must be material to the redemption transaction itself and the gain realized therein, rather than simply being a material factor in ongoing, distributive share income from regular business operations.”  The Tax Court added that the redemption was not in ordinary course of the U.S. LLC’s business, but instead was a “one-time, extraordinary event.”  Thus, the taxpayer’s gain on the redemption of its partnership interest was deemed to be capital gain that was not U.S. source income and that was not effectively connected with a U.S. trade or business.

The outcome in this case is a significant one, although the IRS will likely appeal.  Legislative action is also possible.  MSPC will keep a close eye on this case’s progress, but for the moment, foreign nationals investing in U.S. partnerships may be entitled to tax-favorable treatment in connection with the disposition of their investments, as strong contrary authority now exists with respect to the long-established IRS position.  This may encourage and facilitate transactions that were less appealing to this point.

Please contact Len Sprishen, Tax Manager should you have any questions.