Private equity and venture capital funds often invest in portfolio companies that are formed as partnerships or limited liability companies. But these investments create certain problems for foreign limited partners (LPs) in the form of taxation on the income earned by the partnerships and, at least according to the IRS, U.S. taxation on the gain from the sale of the partnership interests. Recently, the Grecian Magnesite case overturned the IRS’s position that gain on the sale of a partnership interest is taxable to foreign LPs. This article describes the issues that foreign LPs faced in connection with their investments in partnerships, the holding and analysis in the Grecian Magnesite case, and the issues that foreign LPs still face when they invest in partnerships.
Taxation of Foreign Investors in Partnerships Generally
Foreign investors generally are subject to tax in the United States only on their U.S. source fixed or determinable annual or periodical income (FDAP), such as U.S. source interest and dividends (but not including capital gains). The tax is imposed (by way of withholding) at a flat 30 percent (or lower treaty rate).
In addition, foreign investors are subject to tax, on a net basis at regular U.S. tax rates, on any income that is effectively connected to a trade or business in the United States (known as effectively connected income, or ECI). With certain exceptions, such as gain attributable to the sale of U.S. real property interests, nonresident investors are not subject to tax on capital gain unless it constitutes ECI. In addition, foreign corporate investors may be subject to branch profits tax (BPT) at a rate of 30 percent (or lower treaty rate) on ECI that is deemed distributed from the U.S. business to the foreign corporation.
Partners (rather than the partnerships in which they invest) are subject to tax on their distributive share of partnership income. Additionally, the character of income recognized by a partnership (such as interest, dividends or capital gains) retains this character when allocated to the partners. Similarly, if a partnership is engaged in a trade or business, all of its foreign partners are treated as being engaged in the same trade or business. Thus, ECI recognized by a partnership is ECI in the hands of its foreign partners, and these foreign partners generally are subject to tax in the United States in the same manner as U.S. persons (at graduated rates on net income). They also must file U.S. federal income tax returns.
IRS Rulings on Sales of Partnership Interests
In 1991, the IRS issued Revenue Ruling 91-32,1 in which it concluded that the gain or loss of a foreign LP resulting from the sale of an interest in a partnership that conducts a trade or business through a fixed place of business in the United States constitutes U.S. source ECI to the extent that the partner’s distributive share of unrealized gain or loss is attributable to property used by the partnership in a trade or business. As a result, a foreign LP would be subject to tax in the United States on the capital gain it recognizes from the sale of an interest in a partnership if the partnership is engaged in a U.S. trade or business. According to the IRS, tax treaties provided no additional protection to foreign LPs because any gain recognized on the sale of the partnership interest would be considered attributable to the partnership’s office or fixed place of business (i.e., a permanent establishment for treaty purposes) and, thus, treaties would permit the taxation of this gain as business profits.
In September 2012, the IRS Office of Chief Counsel released a memorandum2 reaffirming its position that a foreign partner was subject to tax on gain recognized by the foreign partner on the disposition of its interest in a partnership that was engaged in a trade or business in the United States.
Practical Issues With the IRS’s Position
Investment funds often will form corporate alternative investment vehicles (AIVs) through which foreign LPs can invest in portfolio companies that are formed as partnerships or limited liability companies. The AIVs pay the U.S. tax on operating income. Thus, the arrangement does not eliminate the entity-level tax on operating income. It does, however, mean that the AIV, rather than the foreign LPs, pays the tax (and, in certain cases, may avoid return filing obligations of the foreign LPs).
Moreover, it does not substantially increase the indirect tax burden on the foreign LPs with respect to their share of the operating income compared to what they would have paid had the portfolio company been converted to a corporation (i.e., the corporation would have been subject to tax on the operating income, and the foreign investor would have been subject to withholding tax on the distribution).
If the AIV is a U.S. corporation, the AIV will be subject to tax on the gain on the sale of the underlying LP interest. If the AIV is a foreign corporation, the IRS position is that the AIV similarly will be subject to tax on the gain on the sale of the underlying LP interest. This creates a significant disparity in the tax burden on foreign LPs, even though foreign investors generally are not subject to U.S. tax on their capital gains. The disparity created by these rules could cause certain foreign investors to avoid U.S. private equity funds that invest substantially in U.S. partnerships and limited liability companies.
During President Obama’s term, several federal budget proposals sought to codify the IRS position in Revenue Ruling 91-32. The proposals also suggested withholding certain amounts realized on the sale of a partnership interest. These proposals never were enacted into law, and the questions raised by Revenue Ruling 91-32 have not been addressed by Republican lawmakers or President Trump in connection with their proposals for tax reform.
The Grecian Magnesite Case
The issue was recently the subject of litigation in the Tax Court.3 Grecian Magnesite Mining, Industrial & Shipping Co., SA is a Greek mining and industrial concern that specializes in magnesite. In 2001, Grecian became a founding member of Premier Magnesia, LLC (f/k/a Premier Chemicals LLC), which is treated as a partnership for U.S. tax purposes. Premier extracts magnesite from a mine in Nevada, manages its business through headquarters in Pennsylvania, and conducts all of its operations through offices and facilities within the United States.
On July 21, 2008, Grecian entered into an agreement with Premier to redeem its membership interest. The redemption was accomplished in two phases, each of which generated a gain. Grecian did not report any gain on its 2008 U.S. income tax return from the redemption of its interest in Premier and did not file a tax return in 2009.
On July 13, 2017, the Tax Court4 ruled that the gain was a capital gain that was not U.S. source income and that was not effectively connected with a U.S. trade or business, thereby declining to follow Revenue Ruling 91-32. In its detailed opinion, the Tax Court pointed to four flaws in the government position:
First, the statute sets out a general rule mandating entity treatment in connection with the sale of partnership interests, and exceptions thereto (e.g., for so-called “hot assets”5 and U.S. real estate interests6) must be enacted by Congress.
Second, by providing that the income realized on the sale of a partnership interest shall be considered gain from the sale or exchange of a capital asset (rather than assets in the plural), the intention of the statute precludes a look through to the multiple assets of a partnership.
Third, a general look-through approach would make the exceptions expressly provided by Congress superfluous.
Fourth, the distribution provisions of Subchapter K specifically treat gain as from the sale or exchange of the partnership interest.
Having decided that gain on the redemption resulted from a sale of a single piece of personal property, the Tax Court turned to the international provisions of the Internal Revenue Code. It found that the gain in question was foreign source income that was not ECI. In reaching its conclusion, the Tax Court went through a detailed analysis of the provisions. First, the Tax Court pointed out that the Code provides that all U.S. source income that is not FDAP is deemed to be ECI. Certain types of foreign source income also may be ECI, but the Tax Court determined, and the government agreed, that the gain in question did not fall into these categories. Thus, the gain would be ECI only if treated as U.S. source income.
The Tax Court pointed to the general rule that gain derived by a nonresident of the United States is treated as foreign source income, unless an exception applies. The key exception potentially applicable to the case at hand is a rule that treats income attributable to an office or fixed place of business in the United States maintained by the nonresident as U.S. source income if (i) the U.S. office or fixed place of business is a material factor in the production of the income in question and (ii) the U.S. office regularly carries on activities of the type from which the income in question is derived.
The Tax Court pointed out that the income related to the actual redemption of the partnership interests must be attributable to the office, not, as the government contended, the income of the underlying business that caused the value of the partnership interest to appreciate. The Court held that the material-factor test was not satisfied because Premier’s actions to increase its overall value were not an essential economic element in the realization of the gain.
The determination that Premier’s U.S. office was not a material factor in the production of the gain from the redemption was sufficient to find in Grecian’s favor. However, the Tax Court also addressed the second element — whether Premier’s U.S. office regularly carried on activities of the type from which the income in question is derived. Again, the Tax Court determined that it is the gain from the redemption of partnership interests that must have been derived in the ordinary course of business. As Premier was not engaged in the business of buying or selling interests in itself, it did not do so in the ordinary course of its business.
Status of Grecian Magnesite
It is not certain whether the government will appeal the decision in Grecian Magnesite. The Tax Court was critical of the position in Revenue Ruling 91-32 and in the case itself. Although we understand the policy behind the IRS’s position, its inability to cite relevant authorities or make compelling arguments strongly supports certain tax practitioners’ longstanding view that, except to the extent attributable to U.S. real property interests, the ability to tax foreign LPs on gain from the sale of partnership interests would require legislative change.
Grecian Magnesite did not specifically address the treatment of gain attributable to hot assets held by a partnership. Although the Tax Court seemed to acknowledge that a “look through” rule applies to hot assets, it did so in driving home its point that exceptions to the general rule that gain from the sale of a partnership interest is treated as gain from the sale of a single capital asset are exceptions, and not the general rule. It did not specifically conclude that this gain would constitute ECI. On its face, the rule seems applicable only to ensure that this gain retains its ordinary character, and that partners not be able to benefit from the favorable rates applicable to capital gains. Viewed in this manner (as opposed to doing a full look-through analysis), the gain still typically would be treated as gain from the sale of tangible personal property (which is sourced based on the resident of the taxpayer). Further analysis may be advisable to consider the treatment of gain attributable to hot assets in light of the language in the Grecian Magnesite case.
The Grecian Magnesite case adds support for foreign taxpayers to take the position they are not subject to tax on the gain from the sale of partnership interests, even if the partnership in question is engaged in a trade or business in the United States. It is important to note that this holding does not apply to FIRPTA gain (i.e., gain attributable to U.S. real property interests held by partnerships), which is treated as ECI. Nor does the holding change the general rule that ECI derived by a partnership will flow through, and be taxable, to foreign partners. Thus, private equity funds adverse to ECI likely may still consider forming special purpose vehicles through which to make investments in partnerships engaged in a trade or business in the United States. However, investing through an AIV formed as a foreign corporation can generally allow the AIV to avoid U.S. taxation on the sale of the partnership interest. In addition, foreign investors that have paid the tax on the sale of a domestic partnership may want to consider filing claims for refund before the expiration of the three-year statute of limitation for claiming a refund if they believe that the holding in Grecian Magnesite is authoritative for their situation.