Tax Court's Grecian Decision Could Benefit Foreign Partners (article)
The U.S. Tax Court case, Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, holds major implications for foreign investments in U.S. partnerships. In a case decided on July 13, 2017, the Tax Court sided with the taxpayer, a foreign partner in a U.S. partnership, finding that the gain on redemption of its U.S. partnership interest was nontaxable, rejecting a position that the IRS had maintained for over 25 years.
The case involved the redemption of a foreign partner’s interest in a U.S. partnership, yielding a $6.2 million profit for the foreign partner. The parties agreed that a portion of the profit, $2.2 million, was attributable to U.S. real property and was therefore taxable under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), specifically Section 897(g). As for the remaining $4 million of gain, the taxpayer contended that it was not taxable because the redemption payments for the partnership interest were not U.S. source income that was effectively connected to a U.S. trade or business of the taxpayer.
A foreign corporation is engaged in a U.S. trade or business when it is a member of a partnership that is so engaged. The taxpayer clearly was engaged in a U.S. trade or business under this rule. The U.S. can tax certain types of income earned by a foreign corporation engaged in a trade or business within the Unites States. One type of such income is that which is “effectively connected” to the foreign corporation’s U.S. trade or business. Broadly, the Code provides that “[a]ll income, gain, or loss from sources within the United States…shall be treated as effectively connected with the conduct of a trade or business within the United States.” Gain attributable to a U.S. office of a taxpayer that is incurred in the ordinary course of business carried through that office is treated as effectively connected to the taxpayer’s U.S. trade or business, and therefore taxable.
The Government’s position has long been that the redemption of a foreign partner’s interest in a U.S. partnership does not constitute the sale of an indivisible asset. Instead, the redemption should be treated as if the taxpayer had sold a proportionate share of each of the partnership’s assets. This would have produced taxable income effectively connected to the taxpayer’s U.S. trade or business because the “source” of the income would be within the United States. In fact, the IRS had ruled that this was the correct result as far back as 1991, and it implored the Court to give that ruling “appropriate deference” and treat the redemption as taxable. The Court countered by stating that the ruling deserved deference only to the extent it had the “power to persuade,” which this ruling lacked.
The taxpayer argued that the sale involved a single asset, the partnership interest, which was intangible personal property. It was further argued that the gain from the redemption of the taxpayer’s partnership interest should be nontaxable because it should be sourced to the taxpayer’s residence. The Code is clear that income from the sale of personal property is sourced to the taxpayer‘s residence. Therefore, unless an exception applied, the holding that the redemption was the sale of an indivisible asset, the partnership interest, which is intangible personal property, would put the question of taxability to rest.
Not surprisingly, the IRS also countered that an exception to the general rule of sourcing personal property to the taxpayer’s residence applied in this case. Specifically, the IRS argued that the partnership served as a U.S. office for the taxpayer, and therefore the gain was taxable because it was attributable to such office. The Court summarized the argument of the IRS as follows: “because the appreciation in the value of [the] partnership interest that yielded the disputed gain when the redemption occurred was ultimately generated by activities engaged in at [the partnership’s] offices, the tax law ought to attribute that gain to those offices.”
The Tax Court sided with the taxpayer in finding that the gain should not be attributable to a U.S. office, because the partnership’s actions were not a material factor in the taxpayer’s redemption transaction. The Court noted that the income had to be from “sales…attributable to such office,” and in keeping with its prior holding that the redemption was not a sale of a proportionate share of the partnership’s assets but of the partnership interest, the increased value was not from “sales…attributable to such office.” It concluded that the partnership’s “actions to increase its overall value were not ‘an essential economic element in the realization of the income’.”
The Court also found that the redemption failed the second prong of the U.S. source attribution inquiry – that the gain must be realized in “the ordinary course of the trade or business carried on through that office.” Finding that the income the partnership produced in its “ordinary course” was from magnesite mining and sale, and that the redemption of the partnership interest was an “extraordinary event,” the Court held that the redemption gain failed the second prong, as well.
Implications for Foreign Partners in U.S. Partnerships
Foreign partners that have or are considering sales or redemptions of interests held in U.S. partnerships may want to consider alternative filing positions as a result of the Grecian decision. However, foreign partners that hold such interests through tiered ownership in multiple partnerships may fall outside the scope of this ruling, due to the rationale used by the Tax Court with respect to the type of activity carried regularly by the partnership. And further, companies that are following the principles of the IRS’s argument—that income from partnership interests is taxable—may need to reevaluate their accounting for partnership interest transactions.
That being said, if the Grecian decision stands, foreign investment in a U.S. partnership may become increasingly attractive because of the potential for a tax free exit strategy.
An appeal to the Grecian decision must be made by the IRS within 90 days of the entry of the Tax Court’s decision. Taxpayers should monitor the appeal process as well as other similar cases that are in the courts now, including TELOS CLO 2006-1, Ltd. v. Commissioner, for which petitions were filed in the Tax Court on March 2017. The IRS also could attempt to modify its regulations to provide that similar types of income would be attributable to a U.S. office of a foreign corporation. In fact, those regulations are part of the IRS’s current Priority Guidance Plan. Finally, it is possible that the Grecian decision could be overruled legislatively given that the Obama Administration had proposed to codify the result in Rev. Rul. 91-32 (and also impose withholding on a sale or exchange of a partnership interest).
Our team will be here to help you monitor the updates and the implications Grecian could have on your tax liabilities. For more information, please contact your local CBIZ MHM tax advisor.
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