On July 13, 2017, the Tax Court, in Grecian Magnesite, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. 3 (2017), rejected Rev. Rul. 91-32, 1991-1 C.B. 107, and held that a non-US partner’s gain on the disposition of its interest in a partnership that conducted a US trade or business (USTB) was generally not subject to US tax. This decision has significant implications for non-US partners in US entities classified as partnerships for US tax purposes.
- The Tax Court held that a non-US partner’s gain on the disposition of its interest in a partnership was not attributable to the US office of the partnership and therefore not US-source income, but rather such gain was non-effectively connected, foreign-source income and thus not subject to US tax.
- In so ruling, the Tax Court rejected the Internal Revenue Service’s (IRS) 26-year position, articulated in Rev. Rul. 91-32, that a non-US partner’s gain on the disposition of its interest in a partnership that conducts a USTB is effectively connected income with such USTB to the extent a sale of the underlying assets would give rise to effectively connected income.
- The Tax Court applied the “entity” rather than the “aggregate” approach, finding that, subject to certain statutory exceptions, the US Tax Code treats the disposition of a partnership interest as the sale of an interest in the partnership rather than the sale of a pro-rata share of the partnership’s underlying assets.
Grecian Magnesite Mining, a Greek corporation (GMM), owned an interest in Premier Chemicals LLC, a Delaware limited liability company classified as a partnership for US income tax purposes (Premier). Premier conducted a trade or business in the United States. In 2008, Premier fully redeemed GMM’s interest in Premier for $10.6 million. GMM realized a gain of $6.2 million on the redemption, approximately $2.2 million of which was attributable to Premier’s US real estate.
The parties agreed that, although the gain arose as a result of Premier’s redemption of GMM’s interest in Premier, such gain was nonetheless treated as gain from the sale of GMM’s interest in Premier and therefore governed by section 741, which would characterize GMM’s gain as “gain or loss from the sale or exchange of a capital asset” (subject to section 751). The parties also agreed that, under section 897(g), which provides a special look-through rule applicable to dispositions of interests in partnerships that hold US real property, the $2.2 million of gain attributable to US real property interests was subject to US tax. At issue in Grecian Magnesite was whether the remaining $4 million of gain was subject to US tax (the Disputed Gain).
The IRS argued, based on its position in Rev. Rul. 91-32, that the Disputed Gain should be treated as effectively connected income and, as such, subject to US tax. In Rev. Rul. 91-32, the IRS asserted that a non-US partner’s gain on the disposition of its interest in a US partnership should be analyzed on an “aggregate” basis and, to the extent the assets of the partnership would give rise to effectively connected income if sold by the partnership, the non-US partner’s pro-rata share of such gain should be treated as effectively connected income. The Tax Court found the technical analysis in Rev. Rul. 91-32 to be deficient and, noting that the ruling “lacks the power to persuade,” rejected the IRS position. The Tax Court declined to provide “appropriate deference” to Rev. Rul. 91-32 as argued by the IRS.
The Tax Court found section 741—providing that gain or loss on the disposition of a partnership interest is gain or loss from the disposition of a capital asset—to be an application of the “entity” approach. In this respect, the Tax Court discussed the legislative history of section 741, which represents a codification of a substantial body of case law in which the courts have overwhelmingly ruled that a sale of a partnership interest would be respected as such and would not be treated as a sale of a ratable share of the underlying assets. See, e.g., United States v. Shapiro, 178 F.2d 459 (8th Cir. 1949).
The Tax Court found further support for its conclusion that the Disputed Gain was properly analyzed as gain from the disposition of a single item of personal property (i.e., a partnership interest) rather than a deemed disposition of a pro-rata share of Premier’s assets by citing to specific statutory exceptions providing for an “aggregate” approach, such as the look-through rules under section 897(g) and section 751 (addressing unrealized receivables and inventory). While the Tax Court noted the statutory exceptions apply an “aggregate” approach, it found no basis for an extra-statutory application of the “aggregate” approach in light of the unambiguous language of section 741.
The Tax Court, having determined the Disputed Gain to be from a disposition of a single item of personal property, then analyzed whether the Disputed Gain was subject to US tax. Ordinarily, gain from the disposition of personal property by a non-US person would be foreign-source income under section 865. However, the IRS argued that the Disputed Gain should be treated as attributable to Premier’s US office and, as such, under the “US office” exception to the default rule of section 865, treated as US-source income subject to US tax. The Tax Court rejected this argument, and applied Treas. Reg. § 1.864-6(b), finding that Premier’s US office was not a “material factor” in the Disputed Gain and that the Disputed Gain did not arise in the “ordinary course of business” but rather was an “extraordinary event.” Accordingly, the Tax Court held that the Disputed Gain was non-effectively connected, foreign-source income and thus not subject to US tax.
Rev. Rul. 91-32 has long been criticized by practitioners as inconsistent with the unambiguous language of section 741, and its rejection in Grecian Magnesite is significant. The ultimate implications of Grecian Magnesite will depend on whether the case is appealed and, if so, on the result of any appeal. A legislative response is always possible and, indeed, the Obama administration proposed codifying Rev. Rul. 91-32 on a number of occasions. The Trump administration has yet to address this issue.