After great anticipation, the Tax Court has held that gain realized by a foreign corporation upon the redemption of its interest held in a U.S. partnership is non-U.S. source capital gain that was not effectively connected with a U.S. trade or business. As such, U.S. income tax could not be imposed on the gain.
Although the wheels of justice often turn slowly, the Tax Court ultimately got taxpayers to the right answer in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (July 13, 2017). The case was tried before the Tax Court in 2014, and awaited decision for nearly three years. In addition, for 25-plus years prior to this decision, the IRS has imposed a result that is opposite to the conclusion reached the Tax Court reached.
The facts of the case are straightforward, Grecian Magnesite Mining (GMM), a Greek corporation, invested in a U.S. limited liability company that was taxed as a partnership. GMM had no office or fixed place of business in the United States independent of the partnership. After a number of years, GMM’s partnership interest was redeemed, resulting in a multimillion-dollar gain.
As a foreign corporation, GMM is generally only taxable in the United States on income effectively connected with a U.S. trade or business. However, the Tax Code provides that a nonresident individual or foreign corporation shall be considered engaged in a trade or business within the United States if the individual or foreign corporation is a member of a partnership that is engaged in a U.S. trade or business. Because GMM was deemed to be engaged in a U.S. trade or business by virtue of the partnership interest it owned, the IRS asserted that GMM’s gain from the redemption of its partnership interest was taxable as “effectively connected income” (ECI) in the United States.
The case is particularly noteworthy because the Tax Court declined to follow a longstanding revenue ruling upon which the government relied. In Revenue Ruling 91-32, 1991-1 C.B. 107, the IRS ruled that gain realized by a foreign partner upon disposing of its interest in a U.S. partnership should be treated as ECI to the extent that the underlying partnership assets would give rise to ECI if sold by the partnership. Rev. Rul. 91-32 has been criticized by practitioners over the years for lack of legal authority to support its conclusions. Nevertheless, the IRS continued to assert the principles of Rev. Rul. 91-32 in taxpayer examinations as well as internal agency guidance. Interestingly, the Obama administration proposed to codify the principles of Rev. Rul. 91-32, which itself might suggest that the revenue ruling lacked legal authority (although never enacted, the proposal was included in each of the administration’s budget proposals for 2013 through 2017).
Rather than defer to the IRS’s rationale as set forth in Rev. Rul. 91-32, the Tax Court marched through a methodical analysis of the relevant statutory provisions. The Tax Court rejected the government’s contention that a foreign partner’s liquidation of its interest in a U.S. partnership should be analyzed under an “aggregate” approach whereby gain from the sale of the partner’s interest is deemed to arise from the assets that make up the partnership’s business. Noting that the relevant statutory wording “could hardly be clearer,” the Tax Court instead applied an “entity” approach whereby sales and liquidating distributions of partnership interests are treated not as sales of underlying assets, but as sales of the partnership interest. Moreover, the relevant statutes dictate that gain realized from the sale or exchange of a partnership interest should be treated as the sale of a capital asset. With respect to Rev. Rul. 91-32, the Tax Court noted that its treatment of the partnership provisions of the Tax Code is “cursory in the extreme.”
Next, the Tax Court turned to the relevant rules governing international transactions to determine whether such gain could be taxable as U.S. source income. Under the general default rule, gain from the sale of personal property by a nonresident is sourced outside the United States. Thus, the gain would not be taxable in the United States unless, under an exception to the general rule, such gain is attributable to an office or other fixed place of business maintained by GMM in the United States. For this purpose, the Tax Court assumed without deciding that GMM had an office or other fixed place of business within the United States through attribution of the partnership’s U.S. activities. The Tax Court went on to conclude, however, that the gain in dispute was not attributable to any such office because (i) the U.S. office (via the partnership) was not a material factor in the gain realized upon redemption of the partnership interest, and (ii) the U.S. office does not regularly carry on activities of the type from which the gain is derived. Distinguishing between ownership of a partnership interest and the underlying partnership activities, the Tax Court stated that “the Commissioner conflates the ongoing value of a business operation with gain from the sale of an interest in that business.” The gain realized from the redemption of the partnership interest is distinguishable and separate from the partnership’s ordinary business activities. Based on these findings, GMM’s gain at dispute in the case was not U.S.-source income and therefore not subject to U.S. income tax.
The Grecian case is significant because it represents a stark departure from the treatment the IRS has asserted for many years. Armed with this precedent, non-U.S. investors in partnerships that are engaged in a U.S. trade or business can strategically plan for an exit that may minimize or avoid the partner’s U.S. tax liability. Moreover, non-U.S. partners who sold or otherwise disposed of their partnership interests in recent years should review the nature of any gain upon which U.S. tax was paid with an eye toward a potential refund claim.