On July 13, 2017, the US Tax Court held that a non-US partner's gain on the disposition of its interest in a partnership that conducted a US trade or business (USTB) was generally not subject to US tax. Grecian Magnesite, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. 3 (2017). The Tax Court rejected the Internal Revenue Service's (IRS) 26-year position, articulated in Rev. Rul. 91-32, 1991-1 C.B. 107, that a non-US partner's gain on the disposition of its interest in a partnership that conducts a USTB is effectively connected income with such USTB to the extent a sale of the underlying assets would give rise to effectively connected income. This decision has significant implications for non-US partners in US entities classified as partnerships for US tax purposes.
In Grecian Magnesite, the taxpayer had received a distribution in full redemption of its interest in a US company treated as a partnership. The distribution resulted in a gain, a portion of which was attributable to the company's US real estate. The taxpayer and the IRS agreed that, although the gain arose as a result of a redemption, the gain was treated as gain from a sale of the taxpayer's interest in the company and therefore characterized by section 741 as "gain or loss from the sale or exchange of a capital asset" (subject to section 751). The parties also agreed that the gain attributable to the company's US real property was subject to US tax. At issue was whether the remaining gain was subject to US tax. The IRS also asserted certain penalties, which are discussed in more detail in an Eversheds Sutherland legal alert.
The IRS relied on Rev. Rul. 91-32, which held that a non-US partner's gain on the disposition of its interest in a US partnership should be analyzed on an "aggregate" basis and, to the extent the assets of the partnership would give rise to effectively connected income if sold by the partnership, the non-US partner's pro-rata share of such gain should be treated as effectively connected income. The IRS argued that the ruling was entitled to deference from the Tax Court. The Tax Court found the technical analysis in Rev. Rul. 91-32 to be deficient and, noting that the ruling "lacks the power to persuade," declined to defer to the ruling.
The Tax Court held that the unambiguous language of section 741 adopts the "entity" approach with respect to the disposition of a partnership interest. Treatment of the partnership as an "aggregate" of its various assets was not appropriate under the statutory language or the legislative history, which indicated that section 741 codified longstanding case law applying an "entity" approach. While the Tax Court noted that certain statutory exceptions apply an "aggregate" approach, it found no basis for an extra-statutory application of the "aggregate" approach in light of the unambiguous language of section 741.
The Tax Court then analyzed whether the gain was subject to US tax. Ordinarily, gain from the disposition of personal property by a non-US person would be foreign-source income. The IRS argued that the gain should be subject to the section 865 "US office" exception, which would result in treatment as US-source income. The Tax Court found that, under the relevant regulations, the "US office" exception did not apply. Accordingly, the Tax Court held that the gain was non-effectively connected, foreign-source income and thus not subject to US tax.
Rev. Rul. 91-32 has long been criticized by practitioners as inconsistent with the unambiguous language of section 741, and its rejection in Grecian Magnesite is significant. The ultimate implications of Grecian Magnesite will depend on whether the case is appealed and, if so, on the result of any appeal. A legislative response is always possible and, indeed, the Obama administration proposed codifying Rev. Rul. 91-32 on a number of occasions. The Trump administration has yet to address this issue. Further details regarding Grecian Magnesite are available in an Eversheds Sutherland legal alert.