United States: U.S. Tax Court Bounces Rev. Rul. 91-32: Sales Of Partnership Interests By Foreign Partners May Not Be Subject To U.S. Tax

The practice of tax law is an exercise of statutory interpretation. A recent opinion of the U.S. Tax Court, Grecian Magnesite Mining, Indust. & Ship. Co. v. C.I.R., 149 T.C. No. 3 (July 13, 2017), is illustrative. Grecian Magnesite is also a highly anticipated decision that resolves a lingering debate over the proper U.S. tax treatment of the sale of a U.S. domestic partnership interest by a foreign partner.1 Grecian Magnesite held that a foreign partner's sale or exchange of an interest in a U.S. domestic partnership may (mostly) be excluded from U.S. income tax. In arriving at its conclusion, the Tax Court rejected a controversial Revenue Ruling, Rev. Rul. 91-32, 1991-1 C.B. 107.

Grecian Magnesite involved the redemption of a foreign partner's interest in a Delaware limited liability company, Premier Chemicals, LLC ("Premier"). Grecian Magnesite Mining ("GMM"), the foreign partner, was domiciled in Greece and engaged in foreign mining activities. Its sole U.S. activity consisted of owning a membership interest in Premier. Premier was engaged in the business of mining magnesite at mines located throughout the U.S. In 2008, Premier agreed to redeem GMM's membership interest in a transaction that ultimately produced $6.2 million in gain. Taking the position that the gain was not U.S. sourced or effectively connected income ("ECI") of a U.S. trade or business, GMM neither reported the gain nor paid U.S. tax on the gain.

A foreign business can be subject to U.S. taxation if it either has U.S. sourced income that is "fixed or determinable annual or periodic" income (so-called "FDAP income"), or the foreign business is engaged in a U.S. trade or business during a taxable year and has ECI of the U.S. trade or business.2

Rev. Rul. 91-32 and its Controversy

Rev. Rul. 91-32 was controversial since the date it was released some 26-years ago. The controversy stemmed from the Internal Revenue Service's position to treat a domestic partnership as an aggregate, rather than an entity. By applying an aggregate approach, the Service treated a foreign partner's sale or disposition of an interest in the partnership as if the foreign partner sold a portion of each asset owned by the partnership. As a result, when turning to the income-sourcing rules of the Internal Revenue Code of 1986, as amended (the "Code"), the Service concluded that any gain was U.S. sourced and subject to U.S. tax.

For the astute partnership tax attorneys, the Service's argument in Rev. Rul. 91-32 harkened back the historic policy debate of whether an entity or aggregate approach should be used in determining the U.S. tax of partnership activities. Under an entity approach, the partnership is treated as an entity on to itself. In contrast, the aggregate approach views each partner as a co-owner of the partnership assets. With the enactment of Subchapter K of the Code,3 Congress opted to mostly apply an entity approach to partnership taxation, however, limited exceptions exist to the entity approach. The exceptions force the application of an aggregate approach to certain items of partnership taxation. The treatment of unrealized receivables and inventory items under Section 751 of the Code is one example where the aggregate approach predominates.

To understand why applying the aggregate approach to a foreign partner was controversial, it is helpful to understand how Subchapter K treats the sale or exchange of a partnership interest. Code Section 741 offers a general rule that a sale or exchange of a partnership interest "shall be considered as gain or loss from the sale or exchange of a capital asset."4

Payments received upon a redemption and liquidation of a partnership are treated the same as a sale or exchange; however, the legal analysis requires weaving through three separate Code sections. First, Code Section 736(b) addresses the treatment of payments received by a partner upon liquidation of the interest. That section provides that liquidating payments are considered a distribution by the partnership. Second, the flush language of Section 731(a) provides that any gain or loss recognized upon a distribution shall be treated "as gain or loss from the sale or exchange of the partnership interest of the distributee partner." Third, since Section 731(a) directs that a distribution is to be treated as a sale or exchange of a partnership interest, Code Section 741 is operable. As noted above, Section 741 directs that a sale or exchange of a partnership interest is treated as a sale of a capital asset.

Turning back to Rev. Rul. 91-32, the Service's decision to apply an aggregate approach meant that the source and ECI character of the gain on the foreign partner's deemed sale of the partnership's assets was U.S. source income of a U.S. trade or business with a fixed place of business in the U.S. According to the Service, since the gain was U.S. sourced income of a U.S. trade or business, the gain recognized by the foreign partner was subject to U.S. tax.5

The Grecian Magnesite Decision

Rev. Rul. 91-32 had long been the bane to many tax attorneys. Not only did most tax lawyers disagree with the Service's strained interpretation of the tax law, there were several practical concerns. Most foreign partners exiting a U.S. trade or business were unlikely to willingly comply with Rev. Rul. 91-32. From the foreign partner's perspective, it was questionable whether the Service had jurisdiction to enforce payment of the purported tax. From the U.S. partnership perspective, it could face back-up withholding obligations and concerns with respect to its own consequences if it failed to comply with a back-up withholding obligation.6

From a partnership tax perspective, Grecian Magnesite confirms that the entity approach applies to the sale or redemption of a partnership interest -- even if the selling partner is a non-U.S. partner. From a statutory interpretation perspective, the court's conclusion is not surprising. As outlined above, the plain language of the Code would seem to dictate the exact outcome reached by the Tax Court.

After concluding the redemption of the partnership interest was a sale of a capital asset, the Service's path to taxing GMM's gain was to convince the Tax Court that the gain was ECI of a U.S. trade or business of Premier.7 What was the trade or business of Premier? Was GMM's gain on the sale of its membership effectively connected with Premier's trade or business? Whether the gain was ECI ultimately turned on the proper income sourcing of the gain.

The Code default rule sources a gain arising from the sale of personal property to outside the U.S. if the gain is recognized by a non-U.S. resident. Alternatively, gain can be sourced to a U.S. office if the U.S. office is a material factor in the production of income and the U.S. office regularly carries on activities of the type from which such gain is derived. While engaging in a technical application of the Code's income sourcing rules, the important take-away is that the Tax Court concluded GMM's gain from the sale of an interest in a U.S. partnership was foreign-sourced. Thus, the gain was not subject to U.S. tax, unless another specific tax law exception applied.

An exception did applying to a portion of GMM's gain -- which GMM conceded during trial -- that caused a portion of the gain to be subject to U.S. tax. The exception dealt with the Foreign Investment in Real Property Tax of 1980 (so-called "FIRPTA") rules, which cause the direct or indirect sale of U.S. real property interests to be subject to U.S. taxation.

Planning Opportunities

Grecian Magnesite settles the debate with regard to the proper U.S. tax treatment of a foreign partner's sale of an interest in a U.S. partnership. In many instances, any gain may properly be characterized as foreign-sourced income.

Grecian Magnesite also demonstrates traps for the unwary remain. The entity approach to partnership taxation can be called-off in some instances, with the consequence is that all or a portion portion of a gain derived from the sale of a partnership interest would be subject to U.S. taxation. For example, the FIRPTA rules cause a direct or indirect sale of a U.S. real property interest to be subject to U.S. income tax. For those structuring a foreign partner's sale of its interest in a U.S. partnership, Grecian Magnesite provides certainty with respect to whether the gain can be taxed in the U.S. and also warns the tax planner that individual assets of a partnership still need to be examined to assess whether there is , and the extent of, any U.S. tax exposure.

Footnotes

1. A "partnership" as used in this article refers to entities classified as a partnership for federal tax purposes, including multi-member limited liability companies. The terms "partnership" and "LLC" are used interchangeably.

2. It is noteworthy to stress that the second mechanism for a foreign business to have U.S. tax exposure is tested on an annual tax year basis and is not a permanent taint.

3. The mostly entity approach was originally adopted by Congress with the enactment of the 1954 version of the Internal Revenue Code. The entity approach continued with subsequent enactment of the 1986 Code.

4. Code Section 741 continues by acknowledging a caveat to the capital asset treatment of a sale of a partnership: "except as otherwise provided in section 751 (relating to unrealized receivables and inventory items." The Tax Court in Grecian Magnesite did point to this caveat in rejecting the Commissioner's argument that the aggregate approach should apply to a foreign partner's sale of a partnership interest by pointing out that Congress could have called off the entity approach by specifically directing an aggregate approach to apply such as was done by cross-referencing Code Section 751.

5. The courts and the Service both agreed that a different result is reached if the entity is a C corporation. In the context of the sale of stock of a C corporation by a foreign partner, the Service had conceded that gain would not be U.S. sourced and, thus, not subject to U.S. taxation.

6. There was likely not a basis under the U.S. tax law to impose a withholding tax on proceeds paid to a foreign partner that sold its interest in a U.S. partnership.

7. The Code attributes the trade or business of a partnership to the foreign partners. Thus, a foreign partner is treated as if it directly conducts the trade or business of the partnership.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions