On July 13, 2017, the Tax Court held in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Comm’r, 149 T.C. No. 3 (2017) that the petitioner, a foreign corporation that disposed of its interest in a partnership that was engaged in a U.S. trade or business, was not liable for tax on certain gain recognized on the disposition. In particular, the Tax Court held that the portion of the gain recognized that was attributable to non-U.S. real property interests was capital gain that was not U.S. source income and that was not effectively connected with a U.S. trade or business. Accordingly, the Tax Court held that the foreign corporation was not liable for U.S. income tax on the portion of the gain that was attributable to non-U.S. real property interests.1
In Grecian, a foreign corporation purchased an interest in a U.S. limited liability company that was recognized as a partnership for U.S. tax purposes (hereinafter “PS”) in 2001. PS was engaged in a U.S. trade or business and thus, under IRC §875(1), the foreign corporation was also deemed to be engaged in a U.S. trade or business as a partner in PS. In 2008, the foreign corporation’s interest in PS was redeemed. A portion of the gain recognized by the foreign corporation was attributable to U.S. real property interests and the foreign corporation conceded that such portion of the gain should be ECI and subject to tax under IRC §§ 897(g) and 882.2 The foreign corporation contended that the remainder of the gain (the “disputed gain”) was not subject to U.S. tax.
The central issue in Grecian was whether the disputed gain should be subject to U.S. income tax.
I. Basic Principles
Foreign persons are generally subject to U.S. income tax on (1) U.S. source fixed and determinable, annual or periodic (“FDAP”) income (e.g., dividends, interest, rents, royalties, etc.) and (2) income that is effectively connected with the conduct of a U.S. trade or business (“ECI”). 3
The Commissioner contended in Grecian that the disputed gain recognized by the foreign partner was ECI and thus, subject to U.S. income tax. 4
The Code and Treasury Regulations do not include specific rules that determine the ECI characterization of gain recognized by a foreign partner on the disposition of its partnership interest except for in IRC §897(g) and the Treasury Regulations promulgated thereunder (dealing with U.S. real property interests).
Given the lack of specific guidance, one of two distinct theories of partnership taxation under subchapter K should apply. For income tax purposes, a partnership could be considered as not having its own distinct existence but simply as being an “aggregation” of its partners. Under the “aggregate approach,” each partner is generally treated as an owner of a proportionate interest in the partnership assets. In the context of applying the aggregate approach to the disposition of a partnership interest by a foreign partner (as the Commissioner contended in Grecian), the source and ECI characterization of the gain on the disposition of the partnership interest would be determined based on the assets that make up the partnership’s business.
Under the “entity approach,” a partnership is an entity separate from its partners and a partner generally does not have direct ownership in the partnership assets. Applying the entity approach to the disposition of a partnership interest by a foreign partner (as the taxpayer contended in Grecian), the source and ECI characterization of the gain on the disposition of the partnership interest would be determined based on the sale of a single asset, the partnership interest under IRC § 741 (subject to IRC §§ 751 and 897(g)).
II. Rev. Rul. 91-32 5
The IRS in Grecian relied heavily on Rev. Rul. 91-32 and argued that deference should be given to the ruling. Rev. Rul. 91-32 holds that gain realized by a foreign partner upon the disposition of its interest in a U.S. partnership should be analyzed asset by asset (i.e., an aggregate approach), and that, to the extent the assets of the partnership would give rise to ECI if sold by the partnership, the disposing partner’s pro rata share of such gain on its partnership interest should be treated as ECI. In other words, Rev. Rul. 91-32 essentially adopts a look-through approach similar to IRC §751(a) for inventory and unrealized receivables, except that the revenue ruling applies that look-through approach for a category of assets (i.e., ECI-generating assets) that are not addressed in §751.
Many tax practitioners consider Rev. Rul. 91-32 to be unpersuasive on its technical merits and the Tax Court agreed with such practitioners in Grecian stating that the ruling lacked “the power to persuade” and the revenue ruling’s treatment of certain partnership provisions was “cursory in the extreme.” Thus, the Tax Court declined to defer to Rev. Rul. 91-32 and instead, chose to follow a more conventional reading of the Code and Treasury Regulations to determine whether the disputed gain was ECI.
III. Tax Court Opinion in Grecian
The Tax Court held in Grecian that subchapter K mandates treating the disputed gain as capital gain from the disposition of a single asset. In reaching its conclusion, the Tax Court relied on the statutory text in IRC §§ 736(b)(1), 731(a) and 741.6 In addition, the Tax Court stated that the enactment of IRC §897(g) reinforces the conclusion that the entity approach is the general rule that applies for the sale or exchange of an interest in a partnership because without such a general rule, there would be no need to carve out an exception to prevent U.S. real property interests from being swept into the indivisible capital asset treatment that IRC §741 otherwise prescribes.
The Tax Court also concluded that disputed gain was not U.S. source and not ECI.7 In reaching that conclusion, the Tax Court stated that the “material factor” test in IRC § 864(c)(5)(B) was not satisfied because the office was not material to the transaction itself and the gain realized therein.8 In addition, the material factor test was not satisfied because the partnership’s actions to increase its overall value were not an essential economic element in the realization of the income that the foreign corporation received upon the disposition of its partnership interest.9
The Tax Court also concluded that the “ordinary course” requirement in Treas. Reg. §1.864-6(b)(1) was not satisfied because the gain realized on the disposition of the partnership interest was not realized in the ordinary course of the trade or business carried on through the U.S. office or fixed place of business.10
As the Tax Court concluded that the disputed gain recognized on the disposition of the partnership interests was not attributable to a U.S. office or other fixed place of business, the disputed gain was not U.S. source income under IRC §865(e)(2)(A) and consequently, not ECI. As the disputed gain was determined to not be ECI, the foreign corporation was not liable for U.S. income tax on the disputed gain that was recognized.
Despite the IRS’s longstanding position in Rev. Rul. 91-32, the Tax Court in Grecian ultimately concluded that such a position was not supportable from a technical standpoint under the Code and Treasury Regulations. The decision in Grecian provides additional support that an entity approach (rather than an aggregate approach) could apply in determining the source and ECI characterization of the gain recognized by a foreign partner from the disposition of an interest in a partnership engaged in a U.S. trade or business (subject to IRC §§ 751 and 897(g)) so that certain foreign partners may not be subject to U.S. income tax on a portion or all of the gain recognized. It is not clear at this stage whether the IRS and Treasury will seek to appeal or effectively over-turn the Tax Court’s decision via publication of regulations. Care should continue to be taken in structuring investments to be held by foreign investors.
1 While not the focus of this alert, the Tax Court also held that the petitioner was not liable for penalties on a separate tax liability because it had reasonably relied on the erroneous advice of its accountant.
2 IRC §897(g) provides that under regulations prescribed by the Secretary, the amount of any money, and the fair market value of any property, received by a nonresident alien individual or foreign corporation in exchange for all or part of its interests in a partnership, trust or estate shall, to the extent attributable to United States real property interests, be considered as an amount received from the sale or exchange in the United States of such property.
3 See, IRC §§ 871(a) and (b), 881 and 882
4 See, IRC §§ 865 and 864, along with the Treasury Regulations promulgated thereunder for purposes of determining whether gain is U.S. source and whether gain is treated as ECI.
5 There have been budget proposals in the past under the Obama Administration to codify the holding in Rev. Rul. 91-32.
6 In particular, the Tax Court in Grecian relied on the following language from the relevant Internal Revenue Code sections stating that “[i]n sum, section 736(b)(1) provides that payments such as those giving rise to the disputed gain ‘shall *** be considered as a distribu-tion by the partnership’; section 731(a) provides that such gain ‘shall be considered as gain *** from the sale or exchange of the partner-ship interest of the distributee partner’; and section 741 provides that such gain ‘shall be considered as gain *** from the sale or ex-change of a capital asset.’ (Emphasis added).”
7 Generally, income from non-U.S. sources is not treated as ECI except for certain types of income described in IRC §864(c)(4). As the disputed gain is not a category of income described in IRC §864(c)(4), it would need to be U.S. source to be treated as ECI. IRC §865(e)(2) provides that income from any sale of personal property attributable to a nonresident’s U.S. office or other fixed place of business shall be sourced in the United States. IRC §865(e)(3) states that the principles of IRC §864(c)(5) shall apply in determining whether a taxpayer has an office or other fixed place of business and whether a sale is attributable to such an office or other fixed place of business.
8 IRC §864(c)(5)(B) provides that income gain or loss is attributable to a U.S. office if the U.S. office “is a material factor in the production of such income, gain, or loss” and “the U.S. office “regularly carries on activities of the type from which such income, gain, or loss is de-rived.”
9 The partnership’s efforts to develop, create, or add substantial value to the property sold was not considered a material factor in the realization of the disputed gain by the Tax Court pursuant to Treas. Reg. §1.864-6(b)(2)(i).
10 Treas. Reg. §1.864-6(b)(1) provides that income, gain or loss is attributable to an office or other fixed place of business which a nonres-ident alien individual or a foreign corporation has in the United States only if such office or other fixed place of business is a material fac-tor in the realization of the income, gain, or loss, and if the income, gain, or loss is realized in the ordinary course of the trade or business carried on through that office or other fixed place of business.