Field Attorney Advice (FAA) 20123903F, released in March 2013, reaffirms the IRS’s position in Revenue ruling 91-32, 1991-1 CB 107 that a non-US-resident’s gain from the sale of an interest in a partnership engaged in a US trade or business is subject to US tax: the partnership’s operating income is effectively connected income (ECI), and the gain is also ECI to the extent that the partner’s distributive share of the partnership’s unrealized gain or loss is attributable to the partnership’s ECI property. On the FAA’s facts, the partnership developed and marketed consumer products and was managed from the United States. The FAA’s result differs from the US tax treatment for a non-resident’s gain from the sale of a USco’s shares: generally, that gain is US-tax-exempt—even if the seller is located in a non-treaty jurisdiction—unless USco is a US real property holding company.

The 2013 US federal budget proposes to codify the doctrine in Revenue ruling 91-32 and implement a FIRPTA-like withholding tax regime to enforce the tax’s collection. (See “Foreign Sale of Interest in Partnership with US Business,” Canadian Tax Highlights, June 2012.) Currently, the IRS and practitioners differ on whether the codification of Revenue ruling 91-32 would constitute a change or a clarification of current law. The FAA reiterates the IRS’s position that a codification would only clarify the existing law, but many practitioners disagree and it appears that at least one Big Four accounting firm may be issuing opinions to that effect.

Conducting a US business through a US partnership structure (an LLC or a limited partnership) may offer US tax advantages relative to a corporate structure with respect to annual operating income or loss, including (1) a flowthrough of losses to the owners, (2) avoidance of a second level of US tax on distributions from the entity to its owners (especially important if the owner is located in a non-treaty jurisdiction that may attract a 30 percent US withholding tax on dividends), and (3) the ability to increase the owner’s tax basis in his interest in the entity for his share of the entity’s undistributed income (which may reduce a potential gain on sale).

However, the position in Revenue ruling 91-32—whether it is or becomes the law—results in a disadvantage to a partnership structure (in comparison with a corporate structure) because tax is imposed on the gain from a nonresident’s sale of an interest in the entity. (This is a disadvantage only if the partnership is not primarily a US realproperty holding entity: if either a partnership or a corporation is primarily such an entity, it generally attracts US tax.) Unfortunately, a partnership structure cannot generally be converted tax-free into a corporate structure immediately before the sale, because the step transaction doctrine applies if the conversion’s primary purpose is to exempt a subsequent sale’s gain from US tax or to qualify as a tax-free reorganization under Code section 368.

From a policy viewpoint, the IRS is principally concerned that the non-resident will avoid tax on the gain from a partnership interest’s sale and that the buyer will obtain a basis step-up in the underlying partnership assets, generating a double-dip tax benefit and a permanent avoidance of US tax on any appreciation in the partnership assets if the purchaser’s basis is bumped without tax to the vendor. The concern is valid, but it would be preferable if the nonresident’s gain from the partnership interest sale was US-tax-exempt (like the gain from the sale of a USco’s shares) and the purchaser did not receive a basis step-up in the underlying assets. This alternative allows a non-resident to enjoy the operating-income tax benefits of a partnership structure without the offsetting disadvantage from the gain on a future sale of the partnership interest.

Canadian ownership of US LLC interests is somewhat unusual because generally treaty benefits are not available, but Canadian ownership of US limited partnership interests is fairly common. The FAA position may affect these structures, especially if the Canadian owner holds its limited partnership interest through a Canco: if US tax applies to a nonresident corporate partner’s gain from an LP interest’s sale, the US tax rate is generally the 34 percent federal rate plus applicable state tax, which combined is greater than the Canadian rate. Thus, the net US tax cost after foreign tax credits is material. The stakes are generally even higher for Canadians investing in US LP structures through offshore entities located in non-treaty jurisdictions, if existing law (assuming that Revenue ruling 91-32 is not law until it is codified) generally results in no current US tax and either no or deferred Canadian tax, depending on the particular structure. The IRS and Treasury recently announced that their priority guidance plan now includes section 864, which implements Revenue ruling 91-32. As a practical matter, enforcement of the tax’s collection is likely to remain problematic unless and until new legislation imposes a withholding tax obligation on the buyer.