The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business. In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion. For foreign investors in US businesses (that do not own real estate), this is an important decision.
A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”). For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership. Regs §1.897-7T(a); Notice 88-72.
In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”). In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.
In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3. The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.
Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world. From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US. In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.
The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC. Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC. The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.
Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain. Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible). A foreign investor should be able to rely on this case to avoid paying tax. Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.