On July 13, 2017, the U.S. Tax Court released Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner, 149 T.C. ___ (2017) (available here), in which it declined to follow the IRS’s position in Revenue Ruling 91-32, 1991-1 C.B. 107 (the “Ruling”). In the Ruling, the IRS held a non-U.S. person’s gain from the disposition of an interest in a partnership engaged in a U.S. trade or business is income that is effectively connected to a U.S. trade or business and, thus, subject to U.S. federal income tax. This case has implications for foreign investors contemplating investments in operating partnerships with U.S. business activities (apart from investments in U.S. real property interests).
Gain recognized from the disposition of an interest in a partnership is generally capital gain. Under the Internal Revenue Code of 1986, as amended (the “Code”), capital gain recognized by a non-U.S. person (such as a non-resident alien or foreign corporation) is generally not subject to U.S. federal income tax unless it is effectively connected with such non-U.S. person’s conduct of a U.S. trade or business (“ECI”). Capital gain of a non-U.S. person generally will be ECI only if such gain is attributable to a U.S. office or fixed place of business through which such non-U.S. person conducts a U.S. trade or business (a “U.S. Office”). Such gain would generally be attributable to a U.S. Office only if the activities of such office were a material factor in the production of such gain and the office regularly carries on activities of the type from which such gain is derived.
2. The Ruling
The Ruling concludes that gain recognized by a non-U.S. person from the disposition of an interest in a partnership will be deemed attributable to a U.S. Office of the non-U.S. person to the extent that such non-U.S. person’s distributive share of unrealized partnership gains would be attributable to ECI. Its conclusion seems to rely on an aggregate theory of the partnership whereby the non-U.S. person is treated as selling, through the U.S. Office of the partnership, its proportionate share of the partnership’s assets. The Ruling has often been criticized by commentators as being inconsistent with the Code provisions that generally treat a partnership as an entity, except in limited circumstances (for example, when the partnership holds unrealized receivables or U.S. real property interests).
3. Grecian Magnesite Mining
Grecian Magnesite Mining, Industrial & Shipping Co., S.A. (“GMM”), the taxpayer in the case before the Tax Court, owned an interest in an entity, which at the time was organized as Premier Chemicals, LLC (“Premier”). GMM had no office, employees or business operations in the United States other than through its ownership interest in Premier, which was classified as a partnership for U.S. federal income tax purposes. Premier was engaged in a U.S. trade or business through its ownership interests in various industrial properties in the United States. GMM’s ownership interest in Premier was redeemed for $10.6 million, resulting in $6.2 million of gain. The IRS contended that, under the Ruling, $4 million of that gain was ECI and subject to U.S. federal income tax.
As a matter of administrative law, the Tax Court declined to defer to the Ruling. The Tax Court stated that it only defers to revenue rulings where such rulings interpret the IRS’s own ambiguous regulations. When a revenue ruling does not interpret ambiguous regulations, such a ruling is afforded weight only to the extent of its power to persuade. In this case, the Tax Court was not persuaded by the Ruling and found that a proper interpretation of the Code and regulations led to a contrary conclusion.
The Tax Court examined the Code provisions governing dispositions of partnership interests and found that such provisions generally employed the entity theory of partnership, with special aggregate theory carve-outs for certain situations. The Tax Court concluded that the Ruling and the IRS’s position in the litigation would render such exceptions unnecessary. Furthermore, the Tax Court concluded that, even though a U.S. Office may be a material factor in the ongoing, distributive share income from regular business operations, such a fact is insufficient to transform gain from the redemption of a partnership into income attributable to that office. Also fatal to the IRS argument was the fact that the redemption at issue in the case was not made in the ordinary course of the partnership’s business. Therefore, the Tax Court held that the redemption of GMM’s interest in Premier was not ECI subject to U.S. federal income tax.
Historically, non-U.S. persons have employed a blocker structure to invest in partnerships that are engaged in the conduct of a U.S. trade or business. Such a structure was used to avoid recognizing ECI upon the sale or redemption of the interest in the partnership, which is usually the investment vehicle. Such blocker structures also allow foreign investors to avoid U.S. federal income tax reporting and compliance requirements. Because these blocker structures generally do not provide 100% pass-through taxation, they contain some tax inefficiencies as well as additional administrative costs. The Tax Court’s holding in this case suggests that foreign investors may wish to consider investing directly in U.S. partnership vehicles so long as such investments do not involve substantial investments in U.S. real property interests. We note, however, that the IRS may appeal the Tax Court’s ruling. Furthermore, the IRS may non-acquiesce in the holding of the case and may continue to take a contrary approach in audits and litigation. Finally, notwithstanding the outcome in this case, the blocker structure would continue to benefit foreign investors who wish to avoid current U.S. federal income tax reporting obligations, or wish to invest in U.S. real property interests.