United States: The US Tax Court Rejects IRS Position That Non-US Partners Are Taxed On Sales Of Partnership Interests

The US Tax Court earlier this month issued a decision that rejected a 25-year old IRS Revenue Ruling and held that gain from the sale or other disposition by a non-US person of an interest in a partnership that is engaged in a US business will not be treated as "effectively connected income," and thus generally will not be subject to US federal income tax.1 If not overturned on appeal and not reversed by Congress or Treasury regulations, the decision would dramatically change the tax structuring considerations for non-US persons investing in a partnership conducting a US business.

General Tax Treatment of Non-US Investment in US Business Assets Through Corporations and Partnerships

Non-US persons generally are subject to US tax on two types of income: (i) income that is effectively connected with a US business ("ECI"), and (ii) "fixed, determinable, annual or periodical" income ("FDAP income") from US sources that is not ECI. ECI received by a non-US person is subject to US tax on a net income basis, generally in the same manner and at the same rates as US persons and requires the non-US person to file a US income tax return.2 Capital gains arising from the sale of stocks, securities and other investment assets generally are not subject to US tax, with an exception for gains from the disposition of US real property interests that are subject to tax under FIRPTA.3 Except as provided by FIRPTA, a foreign person generally will not realize ECI if it is not engaged in a US business. Under section 875(1), a non-US person is deemed to be engaged in a US business if it is a partner in a partnership that is engaged in a US business.4

When a non-US person invests in a US business through a US corporation, the US corporation is subject to corporate income tax on the profits of the business, and any dividends paid by the corporation to the non-US investor are subject to US withholding tax at a 30% rate (or at a reduced treaty rate). The non-US investor is not itself subject to US income tax with respect to the operating income of the corporation. If the non-US investor's stock is not a US real property interest under FIRPTA, gain realized on the sale of the stock is generally not subject to US tax. One negative aspect of owning a business through a corporation, as compared to an entity taxed as a partnership, is that a purchaser of corporate stock generally cannot, without the imposition of corporate-level tax, obtain a stepped up basis in the assets of the business when the stock is sold.

When a non-US person invests in a US business through an entity taxed as a partnership for US tax purposes, the partnership is not subject to entity-level tax. Rather, the non-US investor's share of the US business income of the partnership is ECI that is subject to US tax, generally in the same manner and at the same rates as US persons.

As discussed below, the IRS had taken the position that any non-US investor's gain on the sale of its partnership interest is ECI and therefore is subject to US tax (to the extent of the gain attributable to appreciated US business assets of the partnership). Accordingly, in light of this stated position by the IRS, most taxpayers and practitioners generally believed that the optimal structure for a non-US person to invest in a partnership with a US operating business is through a US blocker corporation. Based on the IRS position, the gain on the sale of such a partnership interest would have been taxable to a non-US investor, and the use of the blocker corporation can eliminate or minimize the impact of branch profits tax and also prevents the need for the non-US investor to file US tax returns.[5] As a result, when exiting an investment many non-US investors have attempted to sell their stock in their blocker corporations, rather than having the blocker corporation sell its interest in the partnership. However, if the blocker corporation is sold, the purchaser generally would not be able to obtain a stepped up tax basis in the blocker corporation's share of the partnership's assets and thus the purchaser would seek to negotiate a discount to the purchase price (generally taking into account any net operating losses of the blocker corporation).

IRS Position in Revenue Ruling 91-32

The Internal Revenue Code does not specifically address how to determine the source of gain from the sale of partnership interests or how to determine if such gain is effectively connected with the conduct of a US business. In 1991, the IRS issued Revenue Ruling 91-32,[6] which concluded that gain or loss from the disposition of a non-US person's interest in a partnership that conducts a US business is ECI to the non-US partner to the extent such gain or loss is attributable to unrealized gain or loss in assets used in the US business. The IRS's position was that the relevant Code sections (including, in the IRS's view, section 875, which does not mention source or character) should be applied, in light of Congress's intent in subchapter K to appropriately blend aggregate and entity treatment of partnerships, so as to subject non-US partners to US tax on the sale of a partnership interest in the same manner as if the partnership had sold the non-US partner's percentage interest in each partnership asset (aggregate treatment). To reach this result, the IRS ruled that the sourcing and character rules of sections 865 and 864, respectively, must treat "an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States [as] an ECI asset of a foreign partner."

Grecian Magnesite Mining Decision

In Grecian Magnesite Mining, which was not a "court reviewed" opinion, the Tax Court rejected the IRS's position in Revenue Ruling 91-32, which the judge found was not entitled to deference because it lacked the power to persuade. The Tax Court held that sections 731 and 741 require the gain or loss from the disposition of a non-US person's partnership interest be treated as gain or loss from the disposition of a single indivisible capital asset, the partnership interest itself (entity treatment), unless another Code section (such as section 897(g), which employs a look-through approach in the case of partnerships holding US real property interests) requires a different result. Because the taxpayer in Grecian Magnesite Mining had conceded that gain attributable to US real property interests was taxable income, only the remaining gain was in dispute. In determining the source of the disputed gain, the Tax Court held that such gain was non-US source because no US office of the partnership or the partner participated in the disposition other than by performing merely incidental, clerical functions. The IRS conceded that, in this case, under section 864(c)(4) the taxpayer's non-US-source gain from the disposition of a partnership interest was not ECI, except to the extent attributable to US real property interests. As a result, the taxpayer's disputed gain on the sale of its partnership interest was held not to be subject to US tax.

Potential Impact of Decision

Due to the concern that Revenue Ruling 91-32 could be followed by the courts, equity investments by non-US persons in US operating partnerships commonly have been structured with the use of a US blocker corporation as a holding company (which is often leveraged with shareholder debt to minimize US tax on operating income). Unless the result in Grecian Magnesite Mining is overturned or the law is changed (either by statute or potentially through regulations), the use of a US blocker structure to invest in a US operating partnership will not be as attractive. We note that the Obama administration proposed several times to codify Rev. Rul. 91-32 without any effect. It is possible that the IRS will release a Notice announcing its intent to issue regulations that will not follow Grecian Magnesite Mining. In the case of many partnerships not holding significant US real property assets, it would be more efficient for a non-US investor to invest directly in the operating partnership, particularly if the returns from the investment are expected to be primarily in the form of gain from a sale or redemption of the interest in the partnership rather than in the form of operating profits (which will still be ECI subject to US income tax and potentially branch profits tax). Investors that are concerned about the filing of US tax returns can form a non-US corporate blocker that would hold the partnership interest, pay US tax on operating profits (if any) and file US tax returns. However, the benefit of using a non-US blocker, as compared to a US blocker, is that gains on the sale or redemption of the interest in the partnership generally would not be subject to US tax.

Notably, Grecian Magnesite Mining does not change the taxation of gain treated as ECI under the FIRPTA rules of section 897(g), which provides that amounts received by a non-US partner on the sale or redemption of an interest in a partnership generally are, to the extent attributable to US real property interests, considered as amounts received from the sale or exchange of such property and thus treated as ECI under FIRPTA. But the Tax Court's decision would allow "qualified foreign pension funds," which are exempt from FIRPTA altogether,[7] to avoid US federal income tax on gain realized from the sale of any partnership interest, including interests in partnerships that hold US real estate that is used or held for use in a US business. Qualified foreign pension funds should review their holdings to determine whether any investments in US real estate assets should be transferred into a structure where the real estate is held by a partnership of which the qualified foreign pension fund (including any wholly non-US subsidiary) is a direct partner.

In addition, non-US partners in partnerships engaged in a US business may want to revisit their investment horizons and determine whether an exit in the near-term could accomplish commercial goals as well as tax savings.


1Grecian Magnesite Mining, Industrial & Shipping Co., SA v. CIR, 149 T.C. No. 3 (2017). Unless otherwise noted, all section references herein are to the Internal Revenue Code of 1986, as amended (the "Code").
2 A non-US corporation also may be subject to a "branch profits tax" at a 30 percent rate (or at a reduced treaty rate) upon the withdrawal from the United States of earnings attributable to ECI.
3 The Foreign Investment in Real Property Tax Act of 1980.
4 A US business requires regular and continuous business activity in the United States by the taxpayer or a dependent or independent agent, and whether a US business exists is based on all of the facts and circumstances. Certain exceptions apply, including investing or trading in stocks and securities, which generally is the exception that private equity funds rely on. Real estate development in the United States would generally be treated as a US business.
5 A blocker corporation also could be capitalized in part with debt so that interest deductions may mitigate the corporate-level US tax (subject to limitations on deductibility, as well as potential withholding tax on interest payments).
6 Revenue Ruling 91-32, 1991-1 C.B. 107.
7 Section 897(l).

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