Article written by FGMK Tax Partner Fuad Saba and Tax Manager Jill Boland
On July 13, 2017, the U.S. Tax Court issued its opinion in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, a decision holding that income from the redemption of an interest in a U.S. partnership was not “effectively connected income” (“ECI”) to the non-U.S. partner being redeemed. The decision upended Revenue Ruling 91-32, 1991-1 C.B. 107, in which the IRS concluded that a non-U.S. partner that disposed of an interest in a partnership that was engaged in a U.S. trade or business had ECI, to the extent that the gain was attributable to partnership assets that were used in the conduct of the partnership’s U.S. trade or business.
The case stems from the 2008 redemption of a foreign corporation’s interest in a U.S. limited liability company. Grecian Magnesite Mining (“GMM”), a privately held Greek corporation, held a 12.6% partnership interest in Premier Magnesia, LLC (“Premier”), a U.S. limited liability company (“LLC”) that had elected to be treated as a partnership for U.S. tax purposes. Premier redeemed GMM’s ownership interest effective December 31, 2008.
Premier made two payments totaling $10.6 million with respect to the redemption of GMM’s interest: one payment of $5.3 million in July of 2008, and a second payment in the same amount in January of 2009. GMM realized total gain of $6.2 million as a result of these payments.
GMM did not reflect any gain from the redemption payments on Forms 1120-F for either 2008 or 2009. Upon audit of these returns, the IRS issued statutory notices of deficiency (“SND”) for both years, claiming that, by virtue of GMM’s partnership interest in Premier, the capital gain from the sale (via redemption) of that interest was ECI and thus subject to U.S. income taxation.
GMM conceded under audit that $2.2 million of the gain should have been included as ECI because it was attributable to real property owned by Premier. (FIRPTA, the Foreign Investment in Real Property Tax Act, at Code Section 897, causes gain from the disposition of U.S. real property to be taxed as U.S. source ECI.) Therefore, the Tax Court focused on the tax treatment of the remaining $4 million in gain: was the remaining $4M gain U.S.-source ECI?
Revenue Ruling 91-32
Although the IRS raised Revenue Ruling 91-32 as support for the proposition that the remaining “disputed gain” was U.S.-source ECI, the Tax Court refused to give deference to the ruling, finding that it lacked “the power to persuade” (citing PSB Holdings, Inc. v. Commissioner, 129 T.C. 131, 144 (2007)). The court pointed to several reasons for its view of the ruling, most notably: the improper interpretation of the text of the relevant statutes; the “cursory” analyses of Subchapters K (partnerships) and N (international) of the Internal Revenue Code; and the omission of critical factors in the statutory tests to be applied in determining the proper source of income. The court thereafter performed its own analyses of Subchapters K and N in reaching its decision.
Analyses of Subchapters K and N
Some of the complexities in Subchapter K arise from the tension between the applications of the “entity theory” versus the “aggregate theory” to statutory interpretations. For example, the entity theory is applied in the interpretation of Section 731. This section mandates that, when a partnership makes a distribution, the partner treat any gain or loss recognized as gain or loss from the sale or exchange of a partnership interest. The partner is therefore viewed as entering into a transaction with the partnership itself, rather than with the other partner(s).
In the international context, the regulations under Section 367 apply the aggregate approach to limit the ability of U.S. taxpayers to receive tax-free treatment in certain cases of outbound transfers of property which would otherwise qualify as tax-free reorganizations or liquidations. These regulations treat U.S. partners as having transferred a pro rata share of any property transferred to a foreign corporation through a partnership, rather than the partnership interest itself.
In Grecian, the IRS argued for the aggregate approach (underlying the aforementioned Revenue Ruling,) such that the character of GMM’s gain resulting from the redemption payments would be characterized based on the nature of the underlying assets owned by Premier. This argument would have resulted in the application of the principles of Section 751 to any payments made by a partnership in redemption of a partnership interest. Section 751 provides that when a partner holds an interest in a partnership which owns unrealized receivables or inventory, and the partner transfers that partnership interest in exchange for money or property, the portion of gain or loss attributable to the unrealized receivables or inventory will be considered ordinary income, not capital gain. In contrast, GMM argued that the gain recognized on the redemption of its interest in Premier should receive capital gain treatment as mandated by Section 741, as if the partnership interest, not the individual partnership assets, had been sold. Section 741 provides a general rule that gain or loss realized on the sale or exchange of a partnership interest shall be considered gain or loss from the sale of a capital asset, “except as otherwise provided in section 751.”
The Tax Court concluded that the clear intent underlying Subchapter K was “to provide a general rule that the entity theory applies to sales and liquidating distributions of partnership interests – i.e., that such sales are treated, not as sales of underlying assets, but as sales of the partnership interest.”
The Tax Court found support for its application of the entity theory in the very existence of Sections 751 and 897(g), which specifically identify circumstances under which the character of any gain or loss realized by a partner from the sale or exchange of a partnership interest is determined based on the underlying assets of the partnership, as exceptions to the general rule. The court concluded that the enactment of these exceptions was evidence that section 741, which provides for capital asset treatment and the application of the entity theory, was the general rule, and that, in the absence of specific exceptions, the character of any gain or loss from the sale or exchange of an interest in a partnership should not be determined based on the character of the partnership’s underlying assets (i.e., under the aggregate approach.) Accordingly, the Tax Court found that Subchapter K required the remaining $4 million gain to be treated as capital gain from the disposition of a single asset, namely the partnership interest in the hands of GMM.
Was the Capital Gain ECI?
The Tax Court then turned to the issue of whether the disputed capital gain was effectively connected to the conduct of a trade or business in the U.S.
The IRS claimed, again based on Revenue Ruling 91-32, that GMM’s gain was effectively connected with the conduct of a trade or business in the U.S. The ruling requires that gain recognized by a foreign partner from the disposition of an interest in a U.S. partnership be analyzed on an asset-by-asset basis. To the extent that the underlying assets owned by the partnership would give rise to ECI if sold by the partnership, any gain (indirectly) attributable to such assets must be considered ECI to a foreign partner disposing of an interest in a U.S. partnership.
Recognizing that no section of the Code specifically addresses the sourcing of gain from the disposition of an interest in a U.S. partnership by a foreign partner, the court examined the statutes applicable to the sourcing of gains from the sale of personal property. The general rule, under Section 865(a)(2), with regard to non-residents, is that such income is sourced outside the U.S., subject to exceptions.
The IRS argued that an exception applied in the case of GMM: Section 865(e) sets out the “U.S. office rule” exception, such that a non-resident who maintains an office or fixed place of business in the U.S. will have U.S.-source income from the sale of personal property to the extent that the gain is attributable to that office or place of business. The IRS claimed that GMM’s gain was attributable to a U.S. office, because the gain stemmed from GMM’s “share of the appreciation in value of Premier’s business resulting from Premier’s efforts to improve Premier’s profits” while GMM was a partner. (Effectively, GMM was attributed a U.S. office or place of business by virtue of being a partner in Premier.)
The Tax Court analyzed the question of attribution under the “material factor” and “ordinary course of business” tests prescribed by Section 864(c)(5)(B). Here, income from the sale of personal property is attributable to a U.S. office if: (a) the U.S. office is a material factor in the production of the income; and (b) the U.S. office regularly carries on activities of the type from which such income is derived.
The court found, contrary to the IRS interpretation of these tests, that Premier’s office was not a material factor in the production of the income, namely the redemption that gave rise to the income. The court also found unconvincing the Commissioner’s claim that the income arose from the appreciation in the value of the partnership interest as a result of the business activities of the partnership.
The Tax Court ultimately held that $4 million of GMM’s gain from the redemption of its partnership interest in Premier was foreign-source capital gain that was not ECI, and that GMM had properly not reflected that gain in its U.S. income tax returns.
Life after Grecian
The Tax Court found that the clear wording of the applicable statutes under Subchapter K requires that the entity theory should be the default approach to determining the tax treatment of sales and liquidating distributions with respect to partnership interests. In addition to being an unequivocal repudiation of Revenue Ruling 91-32, the Grecian decision may impact statutory and regulatory international tax provisions that rely on the aggregate theory of partnership taxation. Some examples of these are listed below.
Grecian and Subpart F
Section 954(c)(4), for example, provides that “in the case of any sale by a controlled foreign corporation (“CFC”) of an interest in a partnership with respect to which such corporation is a 25-percent owner, such corporation shall be treated for purposes of this subsection as selling the proportionate share of the assets of the partnership attributable to such interest.” (Italics added.) Granted, GMM was a foreign corporation, not a CFC, but can the court’s finding in Grecian be interpreted as overriding the aggregate approach here? Or would there be valid tax policy reasons for treating a CFC differently from a foreign corporation? Would other instances of aggregate partnership tax theory in Subchapter N be tested against the court’s statement that the general rule should be the application of the entity approach?
Grecian and Section 956
Under Section 956, the increase in investment in U.S. property during the tax year by a CFC is treated as a deemed distribution to the U.S. shareholder of that CFC. The regulations require the application of the aggregate theory to instances in which a foreign CFC partner owns an interest in a U.S. partnership that holds an investment in U.S. property. In other words, the U.S. shareholder of a CFC cannot avoid the inclusion in its current income of CFC earnings & profits arising from a Section 956 investment by the CFC simply by creating a U.S. partnership, with the CFC as a partner, to hold the investment. Does Grecian call into question the appropriateness of the application of the aggregate theory in such a case? Or would the Tax Court consider the aggregate approach to be consistent with the underlying intent of Section 956?
Grecian and Section 367(a)
As explained above, the regulations under Section 367(a) apply the aggregate approach to outbound transfers of property by a partnership with U.S. partners. While this approach has the advantage of discouraging the creation of partnerships solely for tax avoidance purposes, this particular section of the regulations does not involve the sale or transfer of a partnership interest. Should Grecian be narrowly interpreted such that the aggregate approach in such instances is beyond the scope of the Tax Court’s decision?
The immediate impact of the Tax Court’s rebuke of Revenue Ruling 91-32 in the Grecian Mining decision is an open question. The court decision does not and cannot by itself revoke the ruling, and the IRS is likely to appeal the Tax Court’s decision or issue an Action on Decision. However, the decision in Grecian may suggest to foreign investors who recently sold (or were completely redeemed from) interests in U.S. partnerships that they consider filing protective refund claims. This would be for the purpose of preserving the right to recover all or a portion of U.S. federal income tax paid on the gain from a sale or redemption in open tax years. Procedurally, Grecian can impact the U.S. reporting position of taxpayers in similar circumstances, as a Tax Court opinion may support a “more likely than not” position.
From a planning standpoint, non-U.S. partners in a partnership with ECI may want to structure the sale of a partnership business as a sale of the partnership interest rather than the partnership’s assets. While the sale of partnership assets generally results in the imposition of U.S. tax on a non-U.S. partner’s allocable share of the gain in the underlying assets, structuring the sale of a partnership business as a sale of a partnership interest may prevent the imposition of U.S. tax on the gain. Depending on the facts and circumstances, structuring the sale in this way may result in no tax payable by the non-U.S. partner (absent FIRPTA considerations.) In addition, the decision in Grecian may suggest to non-U.S. residents and their tax advisors that the commonly accepted use of C- Corporation “blockers” to invest in U.S. businesses could be replaced with U.S. partnership structures. As with all things tax, stay tuned.
 All Section references are to the Internal Revenue Code of 1986, as amended.
 Although the SND included an assessment of applicable penalties, these are not discussed in this article.
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