On July 13, 2017, the U.S. Tax Court issued its opinion in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, in which the Tax Court held that a non-U.S. person who sells an interest in a partnership engaged in a U.S. trade or business generally is not subject to U.S. federal income tax, except to the extent such interest is attributable to the non-U.S. person’s share of the partnership’s U.S. real property interest. The Tax Court declined to follow the IRS’s position in Revenue Ruling 91-32 that a foreign person’s gain from the sale of an interest in a partnership engaged in a U.S. business is itself treated as effectively connected income (ECI), causing the foreign person to be subject to U.S. federal income tax on such gain. The Tax Court’s decision may provide significant structuring opportunities for foreign investors investing in U.S. businesses that are in pass-through form.
The Tax Court Decision
In 2001, Grecian Magnesite Mining, Industrial & Shipping Co., SA (GMM), a Greek Corporation engaged in the business of extracting, producing, and commercializing magnesite, invested in Premier Chemicals, LLC, a Delaware LLC that is treated as a partnership for U.S. federal income tax purposes and engaged in a U.S. trade or business. In 2008, the LLC redeemed GMM’s interest in exchange for cash. GMM conceded that a portion of the gain on the redemption was attributable to U.S. real property interests held by the LLC and taxable under Section 897(g) of the Code. At issue before the Tax Court was whether the remaining gain from the redemption of GMM’s interest was ECI and therefore subject to U.S. federal income tax.
Based on Revenue Ruling 91-32, the IRS held that the remainder of the gain should be taxable as ECI and therefore subject to U.S. federal income tax to the extent attributable to property of the partnership that was used or held for use in the partnership’s U.S. trade or business.
Whether a foreign person’s sale of a partnership interest results in ECI is largely dependent on whether an interest in a partnership is treated as an interest in an entity (the “entity approach”) or whether an interest in a partnership is treated as an aggregation of assets held by the partnership (the “aggregate approach”). U.S. taxation of partnerships adopts an entity approach for some purposes and an aggregate approach for others.
Revenue Ruling 91-32 applied the aggregate approach and therefore held that the sale of a foreign person’s interest in a U.S. partnership would be treated as if the partner sold its proportionate share of the property held by the partnership. This would result in the foreign seller’s gain to be subject to U.S. income tax if such gain is attributable to the partnership’s underlying property that is used in a U.S. trade or business. The Revenue Ruling was widely criticized for adopting the aggregate approach without the support of any statutory or regulatory authority.
The Tax Court criticized the Revenue Ruling’s analysis as cursory and stated that as a general rule, the Code applies an entity approach when dealing with the transfer of partnership interests unless an exception exists. Therefore, the Tax Court declined to follow Revenue Ruling 91-32 and held that the entity approach should control so that the redemption of GMM’s interest in the LLC should be treated as the sale of an interest in an entity (not the underlying assets) by a foreign person. As such, the gain recognized by GMM should be treated as foreign sourced income under the default rule of Section 865(a) of the Code and not ECI.
If the Tax Court’s decision is not appealed or is sustained on appeal, the decision may have significant implications for how non-U.S. investors structure their investments in partnerships and LLCs that operate a business in the U.S. Many private equity fund structures insert a U.S. “blocker corporation” between a U.S. partnership and the foreign investors to block ECI, thereby preventing attribution of a U.S. trade or business to the foreign investor and relieving foreign investors from U.S. tax reporting obligations. However, the blocker corporation structure is not ideal because the blocker corporation will pay tax on its income. The Tax Court’s holding will allow a foreign investor to invest in a U.S. partnership without inserting a blocker corporation where gain is not expected to be attributable to U.S. real property.
Note, however, that the Tax Court’s decision only affects the treatment of gain on a non-U.S. person’s disposition of an interest in an LLC or partnership. It does not change the general rule that a non-U.S. person is subject to U.S. federal income tax with respect to its distributive share of an LLC’s or partnership’s U.S. source of current income.