In a recent decision, Grecian Magnesite Mining, Industrial
& Shipping Co., SA v. Commissioner, the U.S. Tax Court
declined to follow Revenue Ruling 91-32, and held that gain on the
sale of an interest in an operating partnership by a non-U.S.
partner is not effectively connected income (ECI). The IRS may
appeal the case as the decision upsets its long-standing position
on this issue. The decision, if it stands, may present potential
new planning opportunities for foreign investors that invest in
U.S. operating partnerships.
The taxation of a partnership and its partners is a blend of entity and aggregate theories. The entity theory treats the partnership as an entity, while the aggregate theory treats the partnership as an aggregation of all of its underlying assets. The tension between the entity and the aggregate theories perhaps is most evident in the case of the sale of a partnership interest. Section 741 of the Internal Revenue Code of 1986, as amended (the Code), generally provides for entity treatment on the sale of a partnership interest, subject to exceptions that provide for aggregate treatment, e.g., Section 751.
Generally, a foreign partner in an operating partnership (i.e.,
a partnership that is engaged in a U.S. trade or business) is
deemed to be engaged in the partnership's U.S. trade business,
and the foreign partner's allocable share of the
partnership's taxable income is considered ECI and thus subject
to U.S. tax. The IRS, in Revenue Ruling 91-32, held that a foreign
partner's gain from the sale of its interest in an operating
partnership is considered ECI to the extent attributable to
property used or held for use in the partnership's U.S. trade
or business. In so holding, the IRS effectively adopted an
aggregate theory with respect to the sale of interests in an
operating partnership. The ruling is controversial and has been
criticized by many practitioners and commentators as lacking
statutory basis and exceeding the IRS' authority.
The Tax Court in Grecian declined to defer to the IRS ruling, finding the ruling's analysis of the partnership tax law "cursory in the extreme." Instead, the Tax Court adopted an entity approach, and held that a disposition of a partnership interest is a disposition of an individual capital asset (i.e., the partnership). It further stated that the entity concept embodied in Section 741 is the general rule for the sale of an interest in a partnership, and gain from such sale is generally not ECI absent specific statutory exceptions. Section 897(g) is an example of such a specific statutory exception by applying a partial aggregate approach to a partnership that owns real property.
The Grecian decision, which the IRS may appeal, may provide incentives for a foreign investor to invest directly in an operating partnership, as opposed to investing through a blocker corporation (as foreign investors typically do), because gain on an exit may no longer be subject to U.S. tax. However, a foreign investor holding an interest in an operating partnership would still be required to file a U.S. federal income tax return (and possibly state and local income tax returns) and pay U.S. taxes on its share of the operating partnership's ECI (and possibly state and local taxes). It thus remains to be seen what practical impact this decision may have on the investment decisions of foreign investors.
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