Understanding the Appellate Court’s Reversal in Rawat Case
The D.C. Circuit Court of Appeals recently overturned the Tax Court’s decision in Rawat v. Commissioner, ruling that the taxpayer’s share of gain on the deemed sale of a partnership’s appreciated inventory in 2008 was not U.S. source income.
The taxpayer, Indu Rawat, is a Canadian citizen who lived in India at the time of the transaction under scrutiny. She had been a partner in a U.S. operating partnership and sold her interest in that partnership in 2008. At the time of the sale, the partnership held inventory items with a basis of $6.4 million that were held for sale in the U.S. and were later sold at a profit of $22.4 million. Rawat’s share of that profit, at the time of the sale of her partnership interest, was $6.5 million.
Based on the Tax Court’s holding in Grecian Magnesite Mining, Industrial and Shipping Co. SA v. Commissioner, the parties agreed that the non-inventory portion of Rawat’s gain should not be considered U.S. source income and, therefore, was not subject to U.S. income tax.
However, the IRS contended that this gain should be treated as U.S. source income and, therefore, subject to U.S. income tax. The parties disagreed on how Sec. 751 should be applied. The IRS argued that the taxpayer was deemed to have sold the partnership’s underlying inventory assets, causing the resulting gain to be U.S. source income. Rawat argued that Sec. 751 merely causes a recharacterization of a portion of the gain she realized upon her sale of the partnership interest but that such gain still pertains to the sale of a partnership interest. Under that rationale, the sourcing rules established under Grecian would apply, and the gain would not become U.S. source income.
The D.C. Circuit Court agreed with the taxpayer, ruling that Sec. 751(a) merely establishes the character of the gain from the deemed sale of hot assets, but it does not recharacterize the gain as if it were from the sale of something other than a partnership interest. The Court gave little weight to the legislative history of Sec. 751(a) in its opinion.
Direct Impact
The enactment of the 2017 tax law, commonly known as the Tax Cuts and Jobs Act (TCJA), renders the direct impact of this decision moot for tax years beginning in 2018. The TCJA reestablished the sourcing rules that asset management firms and their tax professionals had come to rely on prior to the Grecian decision by amending Section 864(c)(8) of the Internal Revenue Code. The TCJA amendment expressly states that gain realized by a foreign partner from the sale of an interest in a partnership that is engaged in a U.S. trade or business is deemed effectively connected; however, the gain cannot exceed the total gain that would be realized by the partner if the partnership sold all of its assets at fair value. In addition, the TCJA added Sec. 1446(f), which establishes a withholding requirement on such gains.
While the ruling in Rawat provides little change on the income tax sourcing rules concerning the sale of partnership interests, it may indirectly impact other areas of partnership taxation. Moreover, it implies that entity principles may be given preference over the aggregate principle in other transactions that center on the acquisition, holding or transferring of partnership interests.
Indirect Impact
One such instance involves the proper determination of the holding period for a partnership interest obtained in certain circumstances. For instance, should a transferor partner’s holding period for stock received in an “interests-over” partnership incorporation be treated as long-term? Rev. Rul. 88-111 currently requires bifurcating the holding period between one that is newly established for the share attributable to the transferor’s share of hot assets and one that is “tacked” for the other assets (thereby affording long-term status to the extent it existed for those other assets).
Another instance involves the ability to report gain on the installment method in certain circumstances. For instance, would a taxpayer be able to report the sale of a partnership interest on the installment method without accelerating the portion relating to the partnership’s Section 751(a) gain (as is generally required pursuant to Rev. Rul. 89-108)? The Rawat decision implies that Rev. Rul. 89-108 may be subject to challenge in this respect.
Also, how does the Rawat decision impact the sourcing of gain on the sale of partnership interests for state income tax purposes? Some states have statutory language that requires sourcing the share of such gain to the state where the underlying assets are located; however, sourcing to the taxpayer’s state of domicile would seem to be the logical answer based on the D.C. Circuit Court’s ruling in Rawat.
Take Away
As noted above, the Rawat decision is likely to create ripples through the tax landscape as it pertains to these and similar issues, so asset management firms should continue to monitor its impact.
For guidance or more information, connect with one of our CBIZ tax professionals today. We will continue to keep you informed as these cases progress.