On July 13, 2017, the Tax Court issued an opinion in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Comm’r, 149 TC No. 3 (2017) that could drastically change the U.S. tax treatment of partnership interest sales in the cross-border context by invalidating longstanding IRS Revenue Ruling 91-32. If Grecian is not reversed on appeal or by statute or regulation, the door could be open to more efficient inbound investment structures that would significantly improve the after-tax returns realized by non-U.S. investors on U.S. investments made by private equity funds, master limited partnerships, joint ventures and various other partnerships. On the other hand, many U.S. taxpayers have affirmatively relied upon Rev. Rul. 91-32 and its logic for foreign tax credit and subpart F purposes, so the invalidation of Rev. Rul. 91-32 and its reasoning could have an adverse impact on many outbound investments.
Summary of Key Takeaways
- Non-U.S. investors could see after-tax returns from U.S. partnership investments increase dramatically.
- On the other hand, the invalidation of Rev. Rul. 91-32 and its reasoning could adversely impact outbound investments by U.S. taxpayers.
- Non-U.S. taxpayers would still need to carefully structure their investments to ensure consistency with the reasoning of Grecian, and U.S. taxpayers should consider whether there are ways to distinguish their facts from those in Grecian.
- The IRS is likely to appeal Grecian and may seek to reverse its result by regulation or statute. Thus, the Tax Court’s decision is likely not the end of the story.
A non-U.S. person is generally subject to U.S. taxation on income received from sources within the United States and other income that is “effectively connected with” the conduct of a U.S. business. A non-U.S. partner in a partnership will generally be considered engaged in the partnership’s U.S. business. As a result, a non-U.S. partner will be subject to U.S. tax on its allocable share of the partnership’s U.S. business income. However, gain recognized on the disposition of a partnership interest is generally treated as capital gain arising from the disposition of personal property, except to the extent such gain relates to undistributed partnership income, U.S. real property (under the Foreign Investment in Real Property Tax Act or “FIRPTA”) or “hot assets” (such as unrealized receivables, inventory or assets producing recapture of depreciation and intangible drilling costs) held by the partnership. Gain from the sale of personal property is generally sourced to the taxpayer’s country of residence, resulting in no U.S. tax on such gain.
An important exception to these general sourcing rules applies where a non-U.S. person has a U.S. office or fixed place of business (a “U.S. Office”) to which such gain is attributable, in which case such income will generally be treated as U.S.-source income. However, absent Rev. Rul. 91-32 this exception would be of limited application in most circumstances, as most non-U.S. investors either would not have their own U.S. Offices or would plan their dispositions of partnership interests to not be attributable to their U.S. Offices.
Rev. Rul. 91-32 involved a series of alternative fact scenarios in which a non-U.S. person disposed of its interest in a partnership that was engaged in a U.S. business through a U.S. Office. In the ruling, the IRS applied an “aggregate” theory of partnership taxation to find that the gain recognized by the non-U.S. partner upon the disposition of its interest in the partnership would be U.S.-source gain (and thus subject to U.S. tax) to the extent attributable to U.S. business property of the partnership, regardless of whether that property was U.S. real property or recapture property. Thus, rather than treat the sale of a partnership interest as a sale of capital personal property by the non-U.S. partner and subject to the favorable sourcing rules described above, the ruling essentially treats the non-U.S. partner as though it sold its proportionate share of the underlying assets of the partnership and the resulting gain was attributable to the U.S. Office of the partnership. In light of this, many current inbound investment structures reflect a conservative approach, assuming U.S. tax would be imposed on the entire gain recognized by a non-U.S. investor on the disposition of a partnership interest in accordance with Rev. Rul. 91-32.
In contrast to the inbound context, the aggregate approach of Rev. Rul. 91-32 can be favorable to U.S. taxpayers in certain outbound structures. For example, the IRS applied similar reasoning to that of Rev. Rul. 91-32 in the outbound context in Private Letter Ruling 9142032, in which gain derived from the sale of an interest in a partnership with foreign assets was treated as attributable to a foreign office of the partnership and as foreign-source income. Such foreign-source treatment is frequently desirable to U.S. taxpayers in applying the foreign tax credit rules. In addition, application of an aggregate approach can produce favorable results for U.S. taxpayers in certain circumstances where a “controlled foreign corporation” recognizes gain from the sale of a partnership interest.
Although Rev. Rul. 91-32 has been criticized for containing very little analysis to support its conclusion, Grecian represents the first published court decision addressing the ruling.
Impact of the Tax Court’s Opinion in Grecian
In Grecian a non-U.S. corporate partner in a U.S. limited liability company (LLC) classified as a partnership for U.S. tax purposes redeemed its LLC interests for cash. Although about one-third of the non-U.S. partner’s gain was attributable to the LLC’s U.S. real property and thus subject to U.S. tax under FIRPTA, the remaining two-thirds of its gain was not attributable to U.S. real property or, apparently, hot assets of the partnership. The taxpayer and the IRS disagreed over whether the remaining gain was subject to U.S. tax, with the IRS citing Rev. Rul. 91-32 as dispositive of the issue. Calling the analysis in Rev. Rul. 91-32 “cursory in the extreme,” the Tax Court declined to follow the ruling, finding it to lack the “power to persuade”.
The court came to two important conclusions. First, it rejected the IRS’s application of the aggregate theory for lack of specific supporting authority, holding that the non-U.S. partner is to be taxed on the sale of its partnership interest (capital personal property) rather than on a hypothetical sale of undivided interests in the partnership’s U.S. business property. Second, the court determined that the only way the sale of the partnership interest could be subject to U.S. tax would be if such sale were attributable to a U.S. Office, but that the partnership’s contribution to the appreciation in the value of the foreign investor’s partnership interest, without more, did not make the sale attributable to the U.S. Office of the partnership. Rather, it is necessary for a U.S. Office to have been a material factor in producing the gain from the partnership interest and producing the gain must have been in the ordinary course of the partnership’s business. As would typically be the case with most non-U.S. investors, no such U.S. Office existed in Grecian; the Greek investor did not have its own U.S. Office and the partnership’s U.S. Office had only a tangential relationship to the partnership interest sale. Notably, the Tax Court declined to determine whether the U.S. Office could be attributed from the partnership to a partner because, even if that were required, under the facts of the case the partnership’s U.S. Office did not have the requisite level of connection to the partnership interest sale.
As discussed above, Grecian does not appear to change the tax result under current law to the extent gain is attributable to the partnership’s U.S. real property or hot assets, as the Tax Court seemed to be of the view that the aggregate theory is applied for those purposes. Thus, for example, the case will have less of an impact on the U.S. taxation of the sale of an upstream oil and gas partnership than it would the sale of an oilfield services partnership because the former largely derives its value from U.S. real property. It should be noted that some taxpayers have taken the position under current law that even gain treated as ordinary income with respect to hot assets should not be subject to Rev. Rul. 91-32, but the Tax Court did not address this issue directly. Also, the non-U.S. investor’s residence in Greece as opposed to another country was not determinative, as the Tax Court’s analysis and holding are not dependent upon the terms of any available tax treaty to which the United States is a party.
The following high-level examples are intended to illustrate the potential impact of the Tax Court’s decision on various typical partnership investments:
Example 1: A non-U.S. investor with no U.S. Office of its own (“Investor”) invests in a private equity fund (“Fund”) that makes a $100MM investment in a limited liability company (treated as a partnership for U.S. tax purposes) that operates a U.S. oilfield services business through a leased U.S. Office (“Opco”). Opco holds no significant U.S. real property, but Opco holds depreciable assets and has allocated $60MM of depreciation deductions to the Fund. The Fund later sells Opco for $500MM and recognizes $460MM of gain consisting of $60MM of hot asset ordinary income attributable to depreciation recapture and $400MM of capital gain. Under Rev. Rul. 91-32, the Investor’s entire share of the $460MM of gain upon the sale of Opco would be subject to U.S. taxation. Under Grecian, the Investor’s entire share of the $400MM capital gain would be exempt from U.S. taxation so long as a U.S. Office did not materially participate in the sale of Opco. The Investor would only be subject to U.S. taxation to the extent of its share of the $60MM of recapture gain, assuming it were not otherwise successful in arguing the inapplicability of Rev. Rul. 91-32 to hot asset gain under current law.
Even so, there would still be many structural considerations. For example, in addition to evaluating the participation of Opco’s management and U.S. Office in the sale of Opco, care would need to be taken to identify the U.S. Offices of the Fund and determine the extent of their participation in the sale of Opco. Also, the exit transaction would need to be structured as a sale of the partnership interest of Opco, not a sale of its assets or subsidiaries, and the Investor would likely desire to invest through a special purpose non-U.S. blocker (perhaps in a jurisdiction that has a tax treaty with the United States) such that the blocker, and not the Investor, would satisfy all U.S. tax return reporting obligations.
Example 2: The Investor in Example 1 also invests $10MM directly in 1% of the units of an MLP that owns and operates pipelines. Two years later, the Investor sells the units for $15MM, recognizing $5MM of capital gain (assuming, for simplicity, that the Investor’s basis is still $10MM at the time of the sale and that there are no applicable recapture items). Because the Investor owned less than a 5% interest in a publicly traded entity, all of the Investor’s $5MM gain on the sale would be exempt from taxation under FIRPTA. However, under Rev. Rul. 91-32, the entire $5MM of gain on the sale of MLP units would still be subject to U.S. taxation because the gain is attributable to the U.S. business and U.S. Office of the MLP without regard to FIRPTA. Under Grecian, however the Investor would not be subject to taxation on the $5MM capital gain and would be eligible for the FIRPTA exception under current law.
Due to the fact that most U.S. real property held by MLPs is used in a U.S. business that would give rise to U.S. taxation under Rev. Rul. 91-32, the exception from taxation under FIRPTA for a non-U.S. holder of a 5% or lesser interest in a publicly traded MLP has largely been irrelevant. However, if Rev. Rul. 91-32 were invalidated, the application of the publicly traded FIRPTA exception could exempt from U.S. taxation much of the gain recognized by non-U.S. persons who sell units in MLPs.
Example 3: A U.S. corporation enters into a joint venture with a foreign counterparty via a foreign entity treated as a partnership for U.S. tax purposes. The foreign partnership conducts business operations solely outside of the United States and has a foreign office through which it manufactures and sells products. All of the foreign partnership’s activities are attributable to that foreign office. The U.S. corporation sells its interest in the foreign partnership. Applying the principles of Rev. Rul. 91-32 and consistent with PLR 9142032, the U.S. corporation asserts that gain from the sale of the partnership interest should be treated as foreign-source income.
If the reasoning of Rev. Rul. 91-32 were invalidated by the courts, the U.S. corporation might not be able to successfully treat its gain from the sale of the partnership interest as foreign-source income, and its ability to claim a foreign tax credit on any foreign tax imposed on that gain or on other income of the U.S. corporation might be limited. Note, however, that in certain circumstances a tax treaty with the United States might permit the classification of such income as foreign-source in any event.