On July 13, 2017, the Tax Court, in a reviewed opinion of the court in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3, rejected the long-standing IRS approach (as articulated in Revenue Ruling 91-32) to determining both the source of gain or loss from the disposition of a partnership interest, and whether such gain or loss is effectively connected with the conduct of a U.S. trade or business.
Under the approach espoused by the Tax Court, the source and effectively connected status of such gain or loss would be determined using an "entity" approach, rather than the "aggregate" approach historically employed by the IRS. In many cases, that would mean that a foreign partner's gain on disposition of a partnership interest is not treated as effectively connected income (ECI) or otherwise subject to U.S. tax, even if the partnership is engaged in a trade or business in the United States, unless a specific section of the Code requires the aggregate approach (e.g., U.S. real property interests held by the partnership under FIRPTA).
Facts of the Case
The Grecian case involves the redemption of an interest held by Grecian Magnesite Mining (GMM), a Greek corporation, in Premier Chemicals, LLC (Premier), a limited liability company classified as a partnership for U.S. federal income tax purposes and engaged in the mining business in the United States. In 2008 and 2009, Premier made payments to GMM in redemption of its interest in Premier, resulting in the realization of approximately USD 6.2 million of gain by GMM. Approximately USD 2.2 million of the gain was attributable to U.S. real estate assets. GMM initially did not treat any of the gain as ECI, but later conceded that the gain attributable to Premier's U.S. real property constitutes ECI under Section 897(g), leaving the Tax Court to determine the appropriate treatment of the remaining USD 4.2 million.
Revenue Ruling 91-32
The IRS took the position that the "aggregate" approach should control the tax treatment of the transaction in question. The IRS position in Grecian was based largely on its own analysis in Revenue Ruling 91-32. That ruling analyzed several variations on a fact pattern in which a foreign partner recognized gain on a disposition of an interest in a partnership engaged in a U.S. trade or business through a fixed place of business in the United States. In the ruling, the IRS took the view that it is "appropriate to treat a foreign partner's disposition of its interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States as a disposition of an aggregate interest in the partnership's underlying property for purposes of determining the source and ECI character of the gain or loss realized by the foreign partner" (an application of the so-called aggregate approach). The IRS then proceeded to conclude that the gain realized by the foreign partner on the sale or disposition of its partnership interest should be considered ECI in the same proportion that such partner's distributive share of gain would have been ECI if the partnership had disposed of all of its assets, and set out a methodology for making that determination by tracing through to the individual assets of the partnership.
The Tax Court's Analysis
The Tax Court, in working through the operative provisions of the partnership tax rules, concluded that the redemption payments were properly treated as payments received from a sale or exchange of GMM's partnership interest and, as such, were governed by Section 741.1 Section 741 provides the general rule that gain or loss from the sale or exchange of an interest in a partnership is to be treated as gain or loss from the sale or exchange of a capital asset (i.e., an application of the "entity" approach to partnerships). The Tax Court saw the reference in Section 741 to a singular "capital asset" as evidence of congressional intent to treat the disposition of a partnership interest under the entity approach, even for purposes of determining the source and ECI character of the gain. The Tax Court also appears to have placed considerable weight on the existence of two statutory exceptions to this general rule—namely, Section 751 (applying aggregate principles in determining the character of certain partnership assets) and Section 897(g) (applying an aggregate approach in the case of U.S. real property owned by a partnership), effectively taking the view that non-statutory exceptions to entity treatment on the sale of a partnership interest are not possible. In the course of its analysis, the court expressly declined to follow Revenue Ruling 91-32, finding that its analysis "lacks the power to persuade."
After concluding that the entity approach should prevail in determining the source and ECI character of GMM's gain on the disposition of its interest in Premier, the Tax Court went on to apply the sourcing rules under Section 865, ultimately concluding that the gain could not be treated as a U.S. source under Section 865(e) (which dictates U.S. source treatment if the gain were attributable to a U.S. office or fixed place of business). Central to that conclusion was the Tax Court's finding that Premier's U.S. offices weren't a material factor in generating the gain because it was not regularly involved in sales and redemptions of partnership interests (regardless of whether business activities carried on by Premier through its U.S. offices materially contributed to the value that was realized upon GMM's redemption of its interest). Based on the Tax Court's determination that the gain was from a foreign source, the gain could not be ECI because it doesn't fall into any of the specified categories of foreign-sourced income that may be treated as ECI under Section 1.864-5 of the Treasury Regulations.
Impact of the Decision
This opinion has potentially significant implications for taxpayers who have recently disposed of partnership interests (or had them redeemed), or who are in the process of planning transactions that involve an exit from an investment in an entity classified as a partnership for U.S. federal income tax purposes.
The Grecian decision seems potentially very favorable for foreign partners of partnership carrying on business in the United States. However, the approach taken by the Tax Court does seem to produce some questionable results. For instance, if a U.S. person acquires from a foreign person an interest in a partnership that holds appreciated assets used in a U.S. trade or business and the partnership has a Section 754 election in place, the foreign partner's distributive share of built-in gain in those assets may escape U.S. taxation altogether. Given the stakes, it seems likely that the IRS will appeal this decision, and a legislative response is also possible. Accordingly, taxpayers should closely monitor these developments and take into account the possibility of a reversal or legislative override for purposes of planning around refund claims or future transactions, and assessing the strength of their existing positions.
In addition, the Grecian holding may also adversely impact some taxpayers using pass-through entities in cross-border transactions. For example, non-U.S. persons who have reported effectively connected losses in connection with the disposition of a partnership engaged in business in the United States, or U.S. persons who have relied on the principles of Revenue Ruling 91-32 in sourcing, gain from the disposition of an interest in a partnership that carries on business outside the United States. It also would be interesting to see if there will be a rush to file amended returns for transactions which were reported on the basis of Revenue Ruling 91-32, or how the Tax Court will rule on currently pending cases, such as TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17 (petitions filed 3/22/17).
The IRS has ninety days to appeal this decision, and we'll provide an update when the IRS announces whether it will do so. However, even if this decision is overturned on appeal to the relevant circuit court (which appears to be the Third Circuit), especially given that this was reviewed by the full Tax Court, that may have little impact on how this decision affects taxpayers resident in other circuits for the foreseeable future. It is also notable that the Grecian case (which, on the whole, is viewed as taxpayer-favorable) was litigated over a period of several years and the opinion was authored by Judge David Gustafson, whose earlier career involved a position as Coordinator of Tax Shelter Litigation during his tenure with the Tax Division of the U.S. Department of Justice. This might make Grecian all the more influential in practitioners' minds.