In a recent case, Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, the Tax Court declined to follow the longstanding position of the US Internal Revenue Service (IRS) in Revenue Ruling 91-32 that a non-US partner is subject to US federal income tax on gain from the sale of a partnership interest to the extent the partnership was engaged in a US trade or business. Instead, the Tax Court eliminated the taxation of such non-US partner's gain (subject to a limited exception, discussed below), because the sale of the partnership interest was not itself connected with a US trade or business. This decision could have significant implications in the investment fund context by opening up new structuring opportunities for non-US investors.
General Tax Considerations for Non-US Investors in a US Trade or Business
The United States taxes the income of a non-US person only to the extent the person's income has sufficient nexus with the United States. A non-US person's US taxable income generally falls into one of two categories: (1) passive US-source "fixed, determinable, annual or periodical" income (FDAP income) that is not connected with a US trade or business (such as US-source dividends), and (2) income treated as effectively connected with the conduct of a US trade or business (effectively connected income or ECI), which is deemed to include gain from the disposition of a "US real property interest" (USRPI). A non-US person that is not engaged in a US trade or business generally is subject to a flat 30 percent US federal withholding tax on any FDAP income (subject to reduction pursuant to an applicable tax treaty), and generally is not required to file a US federal income tax return. In contrast, a non-US person with ECI generally is subject to US federal income tax on such ECI at the same graduated rates applicable to US persons and is required to file a US federal income tax return.
When a non-US person invests in a US trade or business conducted in partnership form, the partnership itself generally is not subject to US federal income tax. Rather, any income earned by the partnership, including any ECI, flows through to the partners and, to the extent applicable, is taxed at the partner level. To avoid having to file a US federal income tax return as a result of any ECI, non-US persons typically invest in "active" US partnerships through "blocker" corporations. For the reasons discussed below, investment funds often have employed US, rather than non-US, blockers for this purpose.
Both US and non-US blockers are subject to US federal income tax on their allocable share of ECI from a partnership. In addition, non-US blockers generally are subject to a second level of "branch profits" tax, at a 30 percent rate, on distributions they receive from the partnership, to the extent not reinvested in another US trade or business. Although the branch profits tax generally is eligible for reduction under an applicable tax treaty, non-US blockers often are established in tax haven jurisdictions that have no tax treaty with the United States. In contrast, US blockers generally are not subject to the branch profits tax; however, dividend distributions from a US blocker to its non-US shareholders generally are subject to a second level of US federal withholding tax at a 30 percent rate (subject to reduction pursuant to an applicable tax treaty). Further, liquidating distributions generally are not subject to any US federal income tax. In light of the foregoing, investment funds often prefer to use US blockers to avoid the branch profits tax (which can be administratively burdensome to calculate) and to give treaty eligible non-US investors the ability to reduce the amount of any second level of US federal withholding tax (or potentially eliminate such second level tax by avoiding any nonliquidating distributions).
Revenue Ruling 91-32
In Revenue Ruling 91-32, the IRS effectively applied an "aggregate" approach to the tax treatment of partnerships, pursuant to which partners are deemed to own an undivided interest in each of the partnership's underlying assets. The IRS held that gain realized by a non-US partner from the sale of a partnership interest is treated as ECI and taxable to the partner to the extent attributable to the partnership's underlying US trade or business assets. Although Revenue Ruling 91-32 has generated a lot of criticism amongst tax practitioners, it has not previously been challenged in court.
Tax Court Case
In Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, a Greek corporation redeemed its interest in a US partnership engaged in a US mining business. As an initial matter, the Tax Court stated that a redemption should be treated like a sale. The Tax Court went on to apply an entity (rather than an aggregate) approach, pursuant to which partners generally are treated as owning a direct interest in the partnership and not in the partnership's underlying assets, unless the tax rules specifically provide otherwise (as they do in the case of a partnership owning USRPIs). By virtue of the entity approach, the Tax Court ruled that the non-US partner's gain from the redemption of its partnership interest did not constitute ECI (except to the extent attributable to the partnership's USRPI assets) and, therefore, did not subject the non-US partner to US federal income tax. An instrumental factor in the Tax Court's decision was the fact that neither the partnership's US office nor any US office of the taxpayer regularly engaged in a trade or business of buying and selling partnership interests.
If upheld, the Tax Court's decision would have the following significant implications:
- In certain situations, non-US investors may benefit from using a non-US blocker, instead of a US blocker, to invest in a partnership. With a non-US blocker, less US federal income tax may be generated when the investors exit the partnership. In many cases, investors holding an interest in a partnership through a blocker will exit the partnership by causing the blocker to sell its interest in the partnership and then liquidate. Unlike a US blocker, which would be taxed on all of its gain, a non-US blocker would be taxed only on the gain attributable to the partnership's USRPI assets. Thus, if a partnership does not have a significant amount of USRPI assets, less gain would be generated upon exit if using a non-US blocker rather than a US blocker. However, the benefit of using a non-US blocker must be weighed against the branch profits tax that may be imposed on the non-US blocker. Thus, a non-US blocker may only be beneficial in cases where the amount of the partnership's ECI from its operating activities is expected to be significantly less than the gain generated upon exit.
- Non-US investors that previously invested directly in a partnership, or invested indirectly in a partnership through a non-US blocker, should consider filing a claim for refund with the IRS before the applicable statute of limitations expires if they recently disposed of their interest in the partnership and paid US federal income tax on the realized gain. Although, as discussed below, it currently is not clear if the IRS will appeal or acquiesce in the Tax Court decision, a protective refund claim can be filed.
Although the Tax Court decision could have significant tax implications, fund sponsors and investors should exercise caution going forward because the IRS has not yet indicated whether it will appeal the Tax Court decision (it has through October 11 to do so) or acquiesce thereto (in which case, the IRS would not challenge taxpayers who apply the Tax Court decision to analogous facts). In addition, legislation or Treasury Regulations could be issued to counter the Tax Court decision. Such legislation has, in fact, previously been proposed by the Obama administration. Furthermore, the Tax Court decision was based on a specific set of facts which may or may not be the same in other situations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.