In a key decision released July 13, the US Tax Court has rejected the IRS’s aggregate approach for taxing a foreign partner’s gain on the redemption of its US partnership interest, concluding that the foreign investor was not subject to US taxation.
While the decision, Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. No. 3 (July 13, 2017), provides guidance on the important issue of whether an aggregate or entity approach is appropriate to analyze partnership redemptions, the decision could have even wider effect. The Court’s reasoning potentially calls into question the legitimacy of several other IRS international tax rulings and regulations involving partnerships.
Moreover, the Court’s ruling appears likely to invite an IRS or Congressional response, and could cause some private equity and hedge funds to rethink their structures.
Grecian Magnesite Mining
The facts of Grecian Magnesite Mining are fairly straightforward. The taxpayer was a foreign corporation that invested in a US LLC (taxed as a partnership for US income tax purposes) that was engaged in a trade or business in the United States.
From 2001 through the 2008 taxable year, the taxpayer received allocations of income from the partnership that the taxpayer reported on its form 1120F as effectively connected income (ECI) under sections 864, 865, and 882. In the 2008 taxable year, the taxpayer exercised an option to put (sell) its interest back to the partnership. The taxpayer was redeemed out of the partnership with two payments, the last of which was agreed to be deemed received on the last day of 2008.
The taxpayer was subsequently audited. The IRS applied Revenue Ruling 91-32, concluding that the partnership should be treated as an aggregate and that the taxpayer should be treated as selling its share of the partnership’ assets.
In Revenue Ruling 91-32, the IRS took the position that when a partnership has a US trade or business that is operated through a fixed place of business or permanent establishment in the United States, a foreign partner’s disposition of an interest in the partnership should be treated as a sale of partnership assets because the partner is deemed to be engaged in the business actually engaged in by the partnership and so is treated as disposing of the partner’s share of the underlying assets of the partnership in such a case.
Under that theory, in the instant case, the IRS said the taxpayer should be treated as selling assets that it was treated as owning which were used in the partnership’s trade or business that was attributed to the taxpayer as a partner and, as a result, having US source effectively connected business income.
The taxpayer, on the other hand, argued that it should be treated as selling a single indivisible capital asset, the partnership interest, under sections 731(a) and 741.
Under that theory, the taxpayer would be treated as realizing foreign source non-effectively connected income and, thus, the gain would not be taxable.
Revenue Ruling 91-32 rejected
The Tax Court, through Judge David Gustafson, rejected the IRS argument and its reliance on Revenue Ruling 91-32, finding that the ruling was poorly reasoned and not entitled to deference.
The Court found that the ruling’s reliance on a Congressional statement from the 1954 code that a partnership can be treated as an aggregate of its partners “as appropriate” for the code provision at issue was too general a statement to override the clear wording of sections 731(a) and 741 that a single indivisible capital asset was sold in the transaction.
The Court found that only when Congress has provided an express exception, such as under section 897(g) of the tax code (which applied in this case to a limited extent due to the partnership’s ownership of US real property), or such as section 751 of the code (relating to the sale of a partnership interest where the partnership holds ordinary income assets), can a sale or exchange of a partnership interest be treated as a sale of the partnership’s underlying assets.
US international tax regulations
The narrow issue before the court was whether the sale or exchange of a partnership interest was taxed as ECI or not when the partnership holds assets that generate ECI because the partnership is engaged in trade or business in the US.
However, other IRS tax guidance, principally regulations in the international area such as those under sections 367 (relating to the outbound transfer of property to a foreign corporation where transfers by either the partnership or by its partners are treated as a transfer of the underlying assets of the partnership), 956 (relating to a partner being treated as owning the underlying assets and as issuing the underlying obligations of a foreign partnership), and 1248 (relating to a foreign partnership’s sale of CFC stock where the US partners are treated as selling the stock), rely on the aggregate theory of partnerships to arrive at the rule provided in those regulations, even though the underlying statutes and legislative history say nothing about dealing with partnerships and its partners under those provisions.
As interpretative regulations, those regulations could fall and be declared invalid if those regulations were challenged for their validity by a taxpayer.
The broader holding of the Court in this case could very well be that partnership interests are treated as one single indivisible capital asset unless another statute expressly provides otherwise. Under that view of the law, many of the government’s aggregate partnership regulations and revenue rulings would not survive judicial scrutiny.
IRS, Congress response?
The IRS did not raise the partnership “abuse of entity rule” under regulation section 1.701-2(e) in the case.
Under that regulation, if the IRS determines that it “is appropriate” to treat a partnership as an aggregate of its partners, then the taxpayer must rebut that assertion by showing that the code or regulation provision at issue clearly provides for partnership entity tax treatment and the ultimate tax results of that entity treatment. Very few situations would allow the taxpayer to make such a showing.
If the IRS had raised the regulation, then it would have said that aggregate treatment was appropriate because the partnership itself was engaged in a US trade or business and so the partners are treated as so engaged for purposes of applying sections 864, 865, and 882 of the code.
Then the taxpayer would have had to argue that entity treatment is clearly mandated by sections 731(a) and 741. As can be seen from the court’s opinion, establishing that principle should not be too difficult.
However, when the taxpayer then attempts to establish that the tax results of entity treatment were clearly contemplated, meaning that Congress was aware that selling a partnership interest where the partnership is engaged in a US trade or business (other than activities relating to US real property) would result in the gain not being subject to US tax, it would be much harder to establish that this was contemplated.
Would a showing that section 897(g), for example, provides for an express exception be taken to mean that Congress was aware that in all other cases (except where the code provides otherwise, such as under sections 453(i) or 751(a)), the gain would not be taxable?
Could the IRS shortly issue a notice stating that it will issue regulations overriding the result in this case?
Yes, it could but would those regulations be valid given the clear and well- reasoned opinion of the court? The validity of those regulations would likely be in serious doubt and taxpayers would most likely file form 8275-R and challenge such a regulation in court.
More likely is a Congressional response mandating the result in Revenue Ruling 91-32 given the need for revenue in future tax reform.
Private equity, hedge fund structures
Will Grecian Magnesite lead to the elimination of blocker corporate entities in private equity and hedge fund structures given the fact that unless US real property is involved, the sale or exchange by a nonresident alien or foreign corporation of a partnership interest where the partnership is engaged in a US trade or business would not be subject to US tax?
It is hard to tell if this will happen, at least in the short term, because the case clearly approved of the allocations to the foreign corporation partner attributable to partnership operations in prior years as being subject to US tax. This would not be optimal for a foreign investor.
The case would just allow a foreign investor to exit the fund without any US income tax. And that would mean that either a form 1040NR or 1120F would have to be filed by the nonresident to pick up the operational allocations from the partnership in the tax years before exiting.
In addition, as noted above, the IRS could issue a notice any time in the short term attempting to freeze the market by saying it intends to issue regulations effective
on the date of the notice treating gains in such cases as subject to US tax.
Despite the fact that a challenge to such regulations would most likely be
successful, would investors want to buy into such a headache?
And future Congressional action is clearly a possibility. The Obama administration over the past several budgets proposed statutorily codifying Revenue Ruling 91-32. That could happen at any time and the effective date of such action would be
Still, it is possible that the market will see a large movement by foreign
investors who are directly invested in US partnerships to sell out their interests and not report any gain subject to tax. That has generally been the practice over the
past years. It is likely that the pace of those actions will be accelerated by the
results of the case.
Time will tell.
Update 7/23/2017: For further discussion of the implications of this case, see: US Tax Court decision in Grecian Magnesite could upend international tax regime for partnerships