The U.S. Tax Court, in declining to follow a 1991 IRS Revenue Ruling, provides potential tax planning opportunities.
On July 13, 2017, the Tax Court ruled in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner that a Greek corporation (“Grecian”) was not subject to U.S. taxation on the redemption of its interest in a U.S. partnership that was engaged in a U.S. trade or business, except to the extent the gain on the redemption was attributable to U.S. property interests owned by the partnership.
The Grecian Case
In 2001, Grecian bought an interest in a U.S. limited liability company that was treated as a partnership for U.S. federal income tax purposes (the “Partnership”). Years later, the Partnership redeemed Grecian’s interest in full, resulting in $6.2 million of gain to Grecian. Under the partnership rules of the Code gain or loss recognized on the redemption of a partnership interest is treated as gain or loss from the sale or exchange of a capital asset. The IRS and Grecian agreed that $2.2 million of the gain was attributable to U.S. real property interests owned by the Partnership, and thus subject to U.S. taxation. The remaining $4 million of gain was subject to dispute, with the IRS arguing that such amount was effectively connected income and thus subject to U.S. taxation.
Under Section 882, effectively connected income of a foreign corporation is subject to U.S. taxation. Section 864(c) defines “effectively connected income” to include certain U.S. source and non-U.S. source income. Section 864(c)(2), which determines whether gain or loss from the sale or exchange of a capital asset (i.e., the disputed gain) is effectively connected income, only applies to capital gain from sources within the United States. Thus, Grecian’s gain would be subject to U.S. taxation as effectively connected income only if it was U.S. source income.
The IRS argued that the Tax Court should follow Revenue Ruling 91-32 (the “Ruling”), which held that gain realized by a foreign partner upon disposing of its interest in a partnership should be analyzed asset-by-asset and that, to the extent such assets give rise to effectively connected income if sold by the partnership, the foreign partner’s pro rata share of such gain should be treated as effectively connected income and thus subject to U.S. taxation. The Tax Court, in declining to follow the Ruling, noted that it “lacks the power to persuade.”
Instead, the Tax Court looked to Section 865(a), which provides a general rule for sourcing income from the sale of personal property. Grecian argued that the general rule should apply, and that as a nonresident, Grecian’s sale of the Partnership interest should be foreign source income, and therefore not effectively connected income. The IRS argued that an exception to the general rule, found in Section 865(e)(2)(A), commonly referred to as the “U.S. office rule” applied, because Grecian’s gain was attributable to the U.S. office of the Partnership. The U.S. office rule cross-references Section 864(c)(5), which requires the U.S. office to be a material factor in the production of the income (the “Material Factor Requirement”) and to regularly carry on activities of the type from which such income is derived (the “Ordinary Course Requirement”).
In applying Section 864(c)(5) and the U.S. Treasury regulations, the Tax Court found that neither test was satisfied, noting that the Material Factor Requirement was not satisfied because the Partnership’s “actions to increase the overall value were not ‘an essential economic element in the realization of the income,’” and the Ordinary Course Requirement was not satisfied because the Partnership’s business was magnesite production and sale, not redemption of partnership interests.
Consequently, the Tax Court held that the general rule found in Section 865(a) applied, and the disputed gain Grecian recognized due to the redemption gave rise to foreign source income which was not effectively connected, and therefore not subject to U.S. taxation.
The IRS may choose to appeal the Tax Court’s decision. If the Tax Court’s decision is sustained upon appeal, or if the IRS chooses not to appeal the decision, there may be significant planning opportunities for foreign investors seeking to dispose of partnership interests. Until then, tax advisors should consider the implications of the Tax Court’s decision on how to structure and how to report the sales of partnership interests.