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 certain 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, nor was it effectively connected with a U.S. trade or business.
In its holding
, the Tax Court decisively rejected Revenue Ruling 91-32, which applies the aggregate theory of partnerships to treat foreign persons disposing of partnership interests as disposing of their share of the underlying assets, producing effectively connected income. The decision represents a significant development in the U.S. taxation of nonresident partners in partnerships engaged in a U.S. trade or business. Although the Tax Court’s opinion is subject to appeal, it supports the position that, under the right facts and circumstances, gain from the disposition or redemption of an interest in a partnership engaged in a U.S. trade or business by a foreign partner may not
be subject to U.S. federal income tax.
The taxpayer in the case, Grecian Magnesite Mining, a Greek corporation, purchased an interest in a U.S. limited liability company, Premier, which was classified as a partnership for U.S. federal income tax purposes. Premier operated a mining business in the United States and allocated income to Grecian from 2001 through 2008. In 2008, Premier redeemed Grecian’s partnership interest (making redemption payments in 2008 and 2009), and Grecian realized gain totaling over $6.2 million.
The IRS and Grecian 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, Grecian 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, Grecian 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. Grecian, 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., Grecian’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’s holding
The Tax Court agreed with Grecian, finding 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 Grecian’s gain from the redemption of its partnership interest was gain from the sale or exchange of an indivisible capital asset—i.e., Grecian’s interest in the partnership.
Next, the Tax Court analyzed the rules governing U.S. taxation of international transactions to determine whether Grecian’s gain was subject to tax in the United States. That determination turned on whether, for purposes of Section 882, the gain of Grecian was “effectively connected with the conduct of a trade or business within the United States.” In Rev. Rul. 91-32, the IRS ruled that gain or loss realized by a foreign partner upon disposing of its interest in a partnership 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 declined to follow the IRS’s position in Rev. Rul. 91-32 and instead applied the sourcing rules under Section 865, which provide 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 no exception to this general rule under Section 865 applied. Thus, because Grecian’s gain was foreign-source, Grecian was a nonresident, and no other exception applied, the Tax Court found that Grecian was not subject to tax on the redemption of its partnership interest.
The Tax Court’s opinion in Grecian Magnesite Mining
leaves several unresolved issues that need to be considered before taking a position that gain recognized by a nonresident partner on the disposal of a partnership interest is not subject to U.S. federal income tax.
For example, the analysis in the opinion does not address the potential applicability of Section 751(b), which might have resulted in the partnership being viewed as having purchased Grecian’s share of so-called “hot assets” from Grecian, 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 anti-abuse rules under Treas. Reg. Sec. 1.701-2(e) applied in this case. Also, it is possible that a court in the future may reach a different conclusion under different facts involving a foreign investor in a U.S. partnership, in particular where tiered partnerships or related parties are involved.
The impact of the Grecian Magnesite Mining
decision is that it may present planning opportunities for certain taxpayers. The Tax Court’s opinion supports the position that, under the right facts and circumstances, gain from the disposition or redemption of an interest in a partnership engaged in a U.S. trade or business by a foreign partner may not
be subject to U.S. federal income tax.
Grecian Magnesite Mining
may apply to situations involving a foreign partner’s disposition of a partnership interest (e.g., sale, exchange, or a complete or partial redemption), including indirect dispositions through an intermediary partnership. 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 of partnership investments. Additionally, the Tax Court ruling may impact financial statements, and accruals related to uncertain tax positions. However, taxpayers should be cautious as the case is subject to appeal by the IRS.
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