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Appeals court sides with taxpayer in U.S. office rule case

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Tax Hot Topics newsletter The D.C. Circuit Court of Appeals affirmed the Tax Court in Grecian Magnesite Mining v. Commissioner (No. 17-1268) on June 11, holding that for purposes of the U.S. office rule, the redemption of a U.S. partnership interest should be deemed to have taken place where it occurred rather than the location of the activities underlying appreciation of the redeemed interest.

The taxpayer in the case, Grecian Magnesite Mining (Grecian), is a privately held company incorporated and operated in Greece. In 2001, it acquired a 15% stake in Premier Chemicals, a Delaware limited liability company (LLC) which is classified as a partnership for federal tax purposes. Both companies specialize in mining, processing, and selling mineral magnesite, but Premier operates solely in the U.S. In July 2008, Grecian entered into an agreement with Premier to redeem its interest in the partnership. The redemption resulted in a gain of more than $6 million for Grecian, which was realized over two years. Grecian did not include any of the gain on its 2008 or 2009 tax returns. The IRS determined all of the gain was subject to U.S. tax and Grecian contested.

At issue in the Tax Court was whether the disputed gain was U.S.-source income and thus subject to U.S. tax. Under the Section 865(a), income from the sale of personal property is generally sourced where the taxpayer resides. However, the “U.S. office rule” exception under Section 865(e)(2)(A) provides that if a nonresident maintains an office or fixed place of business in the United States, income from the sale of personal property that is attributable to an office or fixed place of business is sourced domestically. Under Section 865(c)(5)(B), determining if income is attributable to an office or fixed place of business depends on whether the fixed place or business is a material factor in producing such income, gain or loss, or if it regularly carries on the type of activities from which such income, gain or loss is derived.

The Tax Court rejected the IRS’s argument that the disputed gain was attributable to Grecian through Premier’s U.S. office under the U.S. office rule since all of the activities that produced the gain occurred through Premier’s U.S. operations. Grecian did not dispute that it had a U.S. office through Premier. However, it countered that the partnership interest was a single, indivisible capital asset and thus not subject to the U.S. office rule. The Tax Court agreed. It also held for Grecian on a separate, alternative theory, but the IRS appealed only the holding related to the U.S. office rule.

In reviewing the decision, the D.C. Circuit determined that the focus of the U.S. office rule is transactions, not the appreciation of the assets. In applying this to the facts in the case, it held that the redemption transaction was unrelated to activity that Grecian’s U.S. office regularly carries on because Premier was in the mining business, not in the business of redemption. It acknowledged that although partnerships regularly carry on activities like redemptions, the U.S. office rule is concerned with the activities of the actual, physical office or fixed place of business rather than those of the corporate form.

The Tax Cuts and Jobs Act (TCJA) generally overturned the result of Grecian Magnesite with the enactment of Section 864(c)(8), which treats a non-resident alien’s gain of a partnership interest as effectively connected income. As a result, the decision’s impact may generally be limited to any sale, exchange, or disposition occurring before Nov. 27, 2017. For more coverage on the enactment of Section 864(c)(6), see our coverage here and here.
 
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