United States: Rejecting A Revenue Ruling, Tax Court Rules That Foreign Partner Is Not Subject To U.S. Tax On Redemption Of Partnership Interest

On July 13, 2017, in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (2017), the U.S. Tax Court held that gain recognized by a nonresident partner on the redemption of its interest in a U.S. partnership was not taxable because it was not U.S.-source income, and was also not effectively connected with a U.S. trade or business. In its holding, the Tax Court rejected Revenue Ruling 91-32, which applies the aggregate theory of partnerships to treat foreign persons disposing of investments in partnerships as disposing of the underlying assets, producing effectively connected income.

The taxpayer in the case, Grecian Magnesite Mining (GMM), a Greek corporation, purchased an interest in a U.S. limited liability company, Premier Chemicals, LLC, which was taxed as a partnership for U.S. federal income tax purposes. Premier operated a mining business in the U.S. and allocated income to GMM from 2001 through 2008. In 2008, Premier redeemed GMM's partnership interest (making redemption payments in 2008 and 2009), and GMM realized gain totaling over $6.2 million. The IRS and GMM subsequently agreed that $2.2 million was attributable to U.S. real property interests and taxable under the Foreign Investment in Real Property Tax Act (FIRPTA) regime. However, GMM argued that the remaining $4 million was not taxable in the United States.

Consistent with its position in Rev. Rul. 91-32, the IRS argued that the "aggregate" approach to partnership taxation should be used to evaluate the redemption. Under the aggregate theory, GMM would be viewed as selling its share of each of the assets of the partnership, which were effectively connected to Premier's U.S. business. GMM, on the other hand, argued for an "entity" approach where the gain from the redemption on its partnership interest would be gain from the sale or exchange of an indivisible capital asset, i.e., GMM's interest in the partnership, and such gain would not be attributable to a fixed place of business in the United States.

The Tax Court agreed with GMM, holding that under the facts in the case, entity treatment should apply to the gain recognized as the result of the redemption of a partnership interest. Section 736(b) provides that payments in liquidation of a partner's interest made in exchange for the partner's interest in partnership property are considered as distributions from the partnership. Section 731(a) provides that gain or loss recognized in connection with a distribution is considered as gain or loss from the sale or exchange of the distributee partner's partnership interest. Finally, Section 741 provides that the transferor partner recognizes capital gain or loss on the sale or exchange of its partnership interest, except as otherwise provided in Section 751 (relating to unrealized receivables and inventory items). Pulling these provisions together, the Tax Court concluded that GMM's gain from the redemption of its partnership interest was gain from the sale or exchange of an indivisible capital asset—i.e., GMM's interest in the partnership.

Next, the Tax Court analyzed the rules governing U.S. taxation of international transactions to determine whether GMM's gain was subject to tax in the United States. That determination turned on whether, for purposes of Section 882, the gain of GMM was "effectively connected with the conduct of a trade or business within the United States." In Revenue Ruling 91-32, the IRS ruled that gain or loss realized by a foreign partner upon disposing of its interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States will be U.S.-source effectively connected gain or loss. However, it will be U.S.-source effectively connected gain or loss only to the extent that the partner's distributive share of unrealized gain or loss of the partnership would be attributable to property of the partnership that produces effectively connected income.

The Tax Court found the IRS' position in Rev. Rul. 91-32 unpersuasive and declined to afford the ruling's aggregate approach deference. The Tax Court stated in its opinion that "Rev. Rul. 91-32 is not simply an interpretation of the IRS's own ambiguous regulations, and we find that it lacks the power to persuade."

The Tax Court also described Rev. Rul. 91-32's "treatment of the partnership provisions" as "cursory in the extreme." Instead, the Tax Court applied the sourcing rules under Section 865, which provides that, subject to exceptions, income from the sale of personal property (i.e., the partnership interest) by a nonresident shall be sourced outside the United States. The Tax Court found that an exception to this general rule under Section 865 did not apply. The Tax Court specifically addressed one such exception, which provides that the gain or loss from the sale or personal property may be U.S.-source if attributable to a U.S. office or fixed place or business, which it found not to be applicable under the facts presented. Thus, because (1) GMM's gain was foreign-source, (2) GMM was a nonresident, and (3) no other exception applied, the Tax Court found that GMM was not subject to tax on the redemption of its partnership interest.

Notably, the opinion's analysis does not address the potential applicability of Section 751(b), which might have resulted in the partnership being viewed as having purchased GMM's share of so-called "hot assets" from GMM, presumably because (as a footnote in the opinion indicates) the IRS did not assert that Section 751(b) should apply and had not raised it as an alternative position. Additionally, the IRS did not argue that the partnership anti-abuse regulation under Treas. Reg. Sec. 1.701-2(e) applied in this case. Also, it is worth exploring whether the court may have reached a different conclusion under different facts involving a foreign investor in a U.S. partnership, in particular where tiered partnerships or related parties were involved.  

Nevertheless, the result of Grecian Magnesite represents a significant development in the U.S. taxation of nonresident partners in partnerships engaged in a U.S. trade or business, and may present substantial planning opportunities. Taxpayers should consider whether it's possible to obtain a refund if they previously followed Rev. Rul. 91-32, and consider the Tax Court's opinion when planning future exits from partnership investments. Additionally, the Tax Court ruling may impact financial statements and accruals related to uncertain tax positions. However, taxpayers should be cautious (particularly those in the same circuit as GMM) as the case is subject to appeal by the IRS.

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