On July 13, 2017, the US Tax Court (TC) issued its opinion in Grecian Magnesite Mining v. Commissioner, 149 TC 3, holding that a foreign corporation was not subject to US federal income tax on gain from the sale of an interest in a partnership that is engaged in a US trade or business. Taxpayers had been anxiously awaiting the court's decision in this case. Taxpayers were particularly interested to learn how the court would resolve what appeared to be a conflict among tax authorities. In reaching its decision, the court resolved the conflict, criticizing and declining to follow a 25 year old revenue ruling, Revenue Ruling (Rev. Rul.) 91-32, in which the Internal Revenue Service (IRS) considered analogous fact patterns and reached a contrary conclusion.
Background
Under the facts of Rev. Rul. 91-32, a foreign partner realized a gain on the disposition of an interest in a partnership that conducted a US trade or business constituting a "permanent establishment (PE)" in the United States under tax treaty standards. The ruling concluded the gain was taxable to the foreign partner to the same extent as had the partnership itself disposed of all of its US assets at fair market value. The IRS reasoned that since the foreign partner had a US trade or business by reason of section 875(1) (which attributes the US trade or business of a partnership to its partners), the partner's gain on the sale of the partnership interest was attributable to the foreign partner's trade or business in the United States and therefore was US-source income under section 865(e)(2). The IRS further concluded that the partner's US-source gain on the sale of its partnership interest constituted "effectively connected income" because the partnership interest was an asset used or held for use in the partner's US trade or business (within the meaning of the asset-use test of section 864(c)(2) and Treas. Reg. § 1.864-4(c)(2)). The IRS provided very little authority for this position simply stating that "the value of the trade or business activity of the partnership affects the value of the foreign partner's interest in the partnership."
For years, taxpayers questioned the reasoning and conclusions reached in Rev. Rul. 91-32. Nevertheless, the Obama Administration proposed codifying the principles of Rev. Rul. 91-32 and the IRS and the US Department of the Treasury (Treasury) have identified a plan for guidance under Section 864 implementing Rev. Rul. 91-32 relating to sales of certain partnership interests in their 2016-2017 Priority Guidance Plan.
Grecian Magnesite Mining Decision
Against this backdrop, the Tax Court considered the Grecian Magnesite Mining case. The taxpayer, Grecian Magnesite Mining (GMM), a Greek corporation, was a partner in Premier Magnesia, LLC (Premier), a US partnership. Premier was engaged in a US trade or business, and GMM paid US federal income tax on its allocable share of income from Premier's US trade or business.
In 2008 and 2009, Premier redeemed GMM's entire interest for $10.6 million and GMM realized $6.2 million of gain. On the advice of its accountant, GMM did not pay US federal income tax on the gain. The IRS issued a notice of deficiency, taking the position that the entire $6.2 million was subject to US federal income tax. At trial, the parties agreed that $2.2 million of the gain was due to US real property interests (USRPI) held by GMM, and was thus subject to US federal income tax under Section 897(g) which expressly provides that gain from the sale of a partnership interest that is attributable to US real property interests held by the partnership is subject to US tax. Thus, the issue at trial was whether the remaining $4 million of gain attributable to US trade or business assets, other than US real property, was subject to US federal income tax.
To determine whether the redemption consideration was subject to tax in the United States, the Tax Court first analyzed whether the partnership should be treated as an aggregate or as an entity. Under an aggregate theory, which the IRS advanced consistent with its ruling in Rev. Rul. 91-32, the transaction would be treated as a disposition of an aggregate interest in the partnership's underlying property. Under an entity theory, which GMM advanced, GMM would be treated as selling the partnership interest itself.
The Tax Court agreed with GMM that an entity theory should prevail based on the plain language of the partnership provisions of the Internal Revenue Code and thus GMM should be treated as having disposed of its partnership interest, which is a capital asset. In reaching this conclusion, the Tax Court first referred to section 736(b)(1), which provides that payments made in liquidation of the interest of a retiring partner in exchange for that partner's interest in partnership property are treated as a distribution by the partnership to the partner. The Tax Court next referred to section 731(a), which provides that gain or loss recognized on the distribution by a partnership to a partner is treated as gain or loss from the sale or exchange of the partnership interest of the distributee partner. Finally, the Tax Court referred to section 741, which provides that gain or loss recognized on the sale or exchange of a partnership interest is considered as gain or loss from the sale or exchange of a capital asset. Based on this analysis, the Tax Court determined that the complete redemption of a partner's interest in a partnership (such as the redemption by Premier of GMM's partnership interest in Premier) is treated as a sale of a capital asset, except to the extent an exception applies. An example of an exception to this general rule, section 897(g) discussed above, applies an aggregate approach to that portion of the partner's interest in the partnership attributable to US real property interests (USRPIs). Pursuant to section 897(g), the $2.2 million of gain allocable to the USRPI was taxable. To the extent of the gain realized by GMM in excess of the gain attributable to GMM's proportionate share of Premier's USRPIs, however, the court held that GMM sold a singular capital asset—the partnership interest—rather than GMM's proportionate share of the underlying assets of the partnership.
Having determined how to treat the sale, the Tax Court then addressed whether the sale was subject to US federal income tax. Under the facts of the case, the gain from the sale of GMM would be subject to US federal income tax if it was attributable to Premier's US office. Under Section 864, the income would be attributable to Premier's US office if: (1) the US office was a material factor in the production of the income and (2) the US office regularly carried on activities of the type from which the income was derived. The Tax Court determined that neither of these conditions was met, and thus the $4 million of gain was not subject to US federal income tax.
The Tax Court's decision is in conflict with the conclusions reached in Rev. Rul. 91-32. In rendering its decision, the Tax Court therefore analyzed the level of deference that should be afforded to the revenue ruling. The Tax Court was highly critical of the ruling, noting that "[i]ts treatment of the partnership provisions . . . is cursory in the extreme" and criticizing other parts of the ruling as well. Thus, the Tax Court afforded the ruling no deference.
The decision confirms the general rule of section 741: disposition of a partnership interest is treated as the disposition of a capital asset; thus, the entity theory applies. The decision also confirms that in general the principles that apply to tax a non-US person on the disposition of a capital asset apply to the disposition of a partnership interest just as those principles apply to the disposition of any other capital asset.
The IRS has yet to indicate whether it will acquiesce to the Grecian Magnesite Mining decision. The Tax Court entered final decision in the case on September 21, 2017, and the IRS has 90 days from this date to appeal.
Implications
The implications of the Tax Court's decision in Grecian Magnesite Mining will depend in part on whether the decision is appealed and, if appealed, sustained. In addition, it is possible that Treasury and the IRS could promulgate regulations to reinstate the principles of Rev. Rul. 91-32. As previously noted, the 2016-2017 Priority Guidance Plan released by the IRS and Treasury identifies a plan for guidance under section 864 to implement Rev. Rul. 91-32. Finally, it is possible that Congress could enact legislation codifying Rev. Rul. 91-32.
Despite this uncertainty, taxpayers who followed the guidance of Rev. Rul. 91-32 in an open tax year might consider filing a protective amended return that follows the Tax Court's guidance.
Finally, of course, the decision should be considered in any structures involving non-US partners. For example, certain private equity structuring decisions may be affected by the increased likelihood that a foreign partner will not be subject to US tax on gain from the sale of an interest in a partnership that has a US trade or business. Private equity funds commonly structure investments in partnerships with a US trade or business through a "blocker" corporation to protect foreign investors from recognizing ECI and US tax-exempts from recognizing unrelated business taxable income (UBTI). The decision of whether to use a US or foreign blocker for a particular investment often takes into consideration any difference in tax treatment between the two during the period the investment is held, and on disposition of the investment. To the extent Rev. Rul. 91-32 or its principles no longer apply, a foreign blocker has a tax advantage on disposition in that its gain on the sale of a partnership interest with a US trade or business would not be subject to US tax.
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