A recent Tax Court decision, Grecian Magnesite Mining, Industrial & Shipping Co., SA, is an important development for non-US persons investing in US entities treated as partnerships for US tax purposes. The Tax Court, in a decision written by Justice Gustafson, declined to follow the IRS's historic position that a non-US person's disposition of an interest in a partnership which is engaged in a US business is treated as a disposition of an aggregate interest in the partnership's underlying property for purposes of determining the source of gain or loss. Instead, the Tax Court held that a non-US person's sale of a partnership interest will be treated as the sale of a single capital asset and thus not subject to US federal income taxation, except to the extent gain is attributable to certain statutory exceptions, such as the non-US person's share of the partnership's US real property assets.
The Historic IRS Position
The Internal Revenue Code (“IRC”) Section 875 provides that for US income tax purposes a non-US person is considered as being engaged in a trade or business within the US if the partnership of which such non-US person is a member is so engaged. IRC Section 861 and 865 then provide certain sourcing rules so as to determine whether the income allocable to the non-US person by the partnership is subject to US tax (whether as income derived from a US trade or business or as a so-called “fixed or determinable annual income” such as dividends, interest or royalties). IRC Section 1446 then provides for withholding by the partnership on a non-US partner's share of income effectively connected with a US trade or business.
In 1991 the IRS issued Revenue Ruling 91-32 and applied this same “look-through” treatment to determine the taxability of a non-US person's gain from the sale/disposition of a US partnership interest. Under this aggregate approach, the IRS looked through the partnership to conclude that a non-US person was taxable on gain to the extent such gain was attributable to assets effectively connected to the partnership's US business. The IRS's historical ruling essentially adopted the same analysis Congress prescribed in IRC Section 751 for inventory and receivables, held by the partnership, except that the ruling applied that approach for an additional category of assets (i.e., all effectively connected income-generating assets), rather than the more limited scope of the IRC partnership tax rules.
The Tax Court's July 2017 Decision
The Tax Court chose not to follow the “aggregate” approach put forward in Revenue Ruling 91-32. Instead, the Tax Court took a position consistent with what many practitioners have long believed and concluded that an “entity” approach should generally apply. Looking to the partnership tax rules and specifically IRC Section 741, the Court concluded that the entity approach, not the aggregate approach, is the general rule with respect to characterizing gain resulting from the sale or exchange of an interest in a partnership. This entity rule is subject to exceptions relating to gain attributable to US real property assets. However, the Tax Court concluded that no statutory authority existed to allow application of the aggregate theory in the manner prescribed under Revenue Ruling 91-32. Thus, the Tax Court declined to treat the taxpayer as having sold an aggregate interest in the partnership's underlying property, and instead held that the taxpayer should be treated as having sold a single capital asset (i.e., the interest in the partnership itself), the sale of which was not effectively connected with a US business, and thus not subject to US taxation.
This may not be the end of the issue. The Obama administration had proposed codifying Rev. Rul. 91-32 many times in its annual “green book” budget proposals, so the new Trump administration may become inclined to take legislative action as part of more comprehensive tax reform. Further, the IRS expressed concern that the Tax Court did not give deference to the agency's interpretations of law. Nonetheless, the Tax Court's decision offers some welcomed clarity to taxpayers and may provide significant planning opportunities for non-US persons investing in US partnerships.