On July 13, 2017, the U.S. Tax Court (Tax Court) issued a 55-page opinion rejecting the long-standing position of the Internal Revenue Service (IRS) as set forth in Revenue Ruling 91-32 concerning the sale by a foreign person of an interest in a partnership that is engaged in a U.S. trade or business for U.S. federal income tax purposes.2 Specifically, in this taxpayer victory, the Tax Court held that the foreign partner’s gain from the redemption of its partnership interest by a U.S. partnership (to the extent it was not attributable to U.S. real estate) was not U.S.-source income and was therefore also not gain effectively connected with a U.S. trade or business, thereby exempting such gain from U.S. taxation. This opinion, which the IRS may challenge on appeal, is potentially good news for foreign investors in U.S.-focused investment funds, joint ventures or investments in U.S. operating companies treated as partnerships for U.S. tax purposes.
In 2001, Grecian Magnesite Mining, Industrial & Shipping SA, a Greek corporation (Grecian Magnesite), acquired a minority partnership interest in a Delaware limited liability company treated as a partnership for U.S. tax purposes (U.S. Partnership). The U.S. Partnership, through its U.S. office and operations, was engaged in the mining and selling of minerals in the United States. The U.S. Partnership also owned real estate located in the United States. In 2008, an unrelated partner in the U.S. Partnership asked for the redemption of its partnership interest, which triggered a redemption right for all other partners. Grecian Magnesite exercised this redemption right, and the U.S. Partnership redeemed Grecian Magnesite’s minority partnership interest for cash. Grecian Magnesite treated its gain on this redemption as exempt from U.S. taxation, even though Grecian Magnesite (which had no connection to the United States other than its interest in the U.S. Partnership) had been filing U.S. income tax returns in respect of its allocable share of the U.S. Partnership’s taxable income. Relying on Revenue Ruling 91-32, the IRS challenged this tax treatment of the redemption by arguing that the gain from the redemption of the partnership interest was U.S. source gain effectively connected with the U.S. Partnership’s trade or business within the United States to the extent that the built-in gain or loss in the U.S. Partnership’s assets would be effectively connected with a U.S. trade or business. Grecian Magnesite took the matter to the Tax Court, and the Tax Court ruled in favor of Grecian Magnesite. The Tax Court reasoned as follows:
- Section 741 and Section 731 apply the so-called “entity approach” to an actual or deemed sale of a partnership interest, treating it as a deemed sale of a partnership interest. Accordingly, unless an exception applies, there is no room for the so-called “aggregate theory” of partnership taxation, which would look to the partnership’s assets, in the case of a sale of a partnership interest. The only relevant exception is Section 897(g), which, by its terms, is limited to U.S. real estate. Based on Section 897(g), the IRS and Grecian Magnesite agreed that, to the extent the gain from the redemption was attributable to the U.S. real estate of the U.S. Partnership, it was subject to U.S. taxation.
- The gain from the sale of the U.S. Partnership interest was foreign source income under Section 865(a)(2), which provides that the gain from the sale of personal property (the redeemed partnership interest) by a foreign corporation is sourced by reference to residence of the seller. The only relevant exception to this rule is the so-called “U.S. office rule” of Section 865(e)(2)(A). Under the U.S. office rule, if the foreign taxpayer maintains an office in the United States and income from any sale of personal property is “attributable to such office,” then such gain will be U.S.-source gain. Under the principles of Section 864(c)(5), gain is attributable to a U.S. office only if (1) the U.S. office is a “material factor” in the production of such gain; and (2) the U.S. office “regularly carries on activities of the type from which such gain is derived.” The IRS argued that, because the appreciation in the value of the redeemed partnership interest was generated by activities engaged in at the U.S. Partnership’s offices, the tax rules ought to attribute the gain to the offices of the U.S. Partnership and then attribute the offices of the U.S. Partnership to its foreign partner, Grecian Magnesite. The Tax Court, however, rejected the view that the U.S. Partnership’s offices (which the Tax Court assumed, without holding, were attributable to Grecian Magnesite) were a material factor in creating the redemption gain because, in the context of other income, the Treasury regulations provide that the creation of value in an asset by a U.S. office is not sufficient for such office to be regarded as a “material factor” in the production of income from that asset. Because (1) the U.S. Partnership had engaged in only very few redemptions (two in seven years); (2) the U.S. Partnership was in the business of mining and selling minerals (and was not in the business of selling itself); and (3) there were no negotiations involving the redemption, the Tax Court also concluded that the redemption of Grecian Magnesite’s partnership interest was an extraordinary event and therefore not an activity “regularly carried on” by the U.S. Partnership. Accordingly, neither requirement of the “U.S. office rule” was met, and, as a result, the general rule treating the gain as foreign source applies.
- Revenue Ruling 91-32 provides only a cursory and incomplete analysis of the issues of statutory interpretation presented and, as a result, has no “power to persuade.” Courts are not bound by the IRS’ revenue rulings, and in this instance the Tax Court rejected the conclusions and the reasoning of the ruling and did not follow it.
- Because the gain from the redemption was foreign source income and because this foreign source income was not income effectively connected with a U.S. trade or business (the parties agreed that none of the relevant exceptions applied), the gain from the redemption was not income effectively connected with a U.S. trade or business (ECI).
Our initial observations are as follows:
- The IRS’ position in Revenue Ruling 91-32 has been considered controversial and has long been discussed among tax advisers and taxpayers. In light of such discussions, the Obama Administration intended to codify the ruling position, and Treasury has announced that it intends to issue regulations on this issue. However, neither the legislation nor Treasury regulations have been adopted. While it remains unclear whether any such changes are forthcoming in connection with the Trump Administration’s proposed tax reform, the Tax Court’s ruling might cause Congress to act on this matter.
- It seems likely that the IRS will appeal the decision and announce that it will not follow the Tax Court’s ruling. The redemption case, which is not discussed in Revenue Ruling 91-32, is arguably the stronger case for the IRS’ policy position than a sale of a partnership interest because, unlike in a sale, the partnership itself is involved in, and is a party to, the transaction.
- Foreign taxpayers who have filed income tax returns and paid income tax consistent with the holding of Revenue Ruling 91-32 may want to consider filing amended income tax returns, claiming a tax refund.
- The Tax Court’s decision highlights that if the IRS wants to secure deference from a court in respect of its revenue rulings, these rulings should incorporate, and be argued on the basis of, the IRS’ technical analysis.
We will continue to monitor these developments closely.