United States: U.S. Tax Court Ruling Exempts Gain On Foreign Partner's Sale Of A Partnership Interest

On July 13, 2017, the U.S. Tax Court issued a decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3, which could have a significant impact on how non-U.S. investors invest in U.S. pass-through entities. The Tax Court decision rejected a longstanding Internal Revenue Service (IRS) revenue ruling that held that a non-U.S. investor's capital gain from the sale of an interest in a partnership that is engaged in a U.S. trade or business generally is not subject to U.S. federal income tax, except to the extent attributable to the non-U.S. person's share of the partnership's U.S. real property interests.


The case involved a Greek corporation that had invested in a Delaware limited liability company (LLC) treated as a partnership for U.S. income tax purposes and engaged in a U.S. trade or business. The corporation's interest was redeemed by the LLC for cash. Based on Revenue Ruling 91-32, the IRS asserted that the portion of the corporation's gain that was allocable to the unrealized gain in the assets used by the LLC in its U.S. trade or business was taxable as effectively connected income (ECI).

Revenue Ruling 91-32 concluded that gain from the sale of a partnership interest should be taxed in the United States as ECI if the seller is a non-U.S. person and the partnership carries on a U.S. trade or business, adopting an "aggregate theory" approach to treat a partnership interest as an aggregation of assets held by the partnership, instead of an "entity theory" approach which would treat a partnership interest as an interest in an entity. 1

The revenue ruling's controversial position led commentators to assert that its conclusion conflicted with applicable statutory provisions that generally apply an "entity theory" approach to a sale of a partnership interest, rather than an "aggregate theory" approach.

In Grecian Magnesite, the Tax Court refused to follow Revenue Ruling 91-32, concluding that it was an incomplete analysis of the statutory interpretation issues involved and therefore had no "power to persuade."

Deviating from the revenue ruling's approach, the Tax Court viewed the taxpayer corporation's gain as being from the sale of an indivisible capital asset (i.e., the partnership interest under an "entity theory" approach) based on the literal language of Sections 731(a) and 741 of the Internal Revenue Code.

The Tax Court then looked to the general gain recognition and sourcing rules under the Internal Revenue Code to determine whether the gain should be treated as U.S.-source income.

The Tax Court analyzed the "U.S. office rule" under Section 865(e)(2)(A) of the Internal Revenue Code, which provides that gain from the sale of personal property (i.e., the sold U.S. partnership interest) is U.S.-source gain only if (1) the U.S. office is a "material factor" in the production of such gain; and (2) the U.S. office "regularly carries on activities of the type from which such gain is derived."

The Tax Court found that in order for the gain to be attributable to a U.S. office, that office's activities must be material to the transaction resulting in the gain itself, and not just a material factor in the ongoing income derived from the partnership's regular business operations.

As the gain from the taxpayer corporation's sale transaction was deemed to be a one-time, extraordinary event that was not an activity "regularly carried on" by the U.S. partnership, neither of the two requirements under the "U.S. office rule" was met and the gain was not U.S. source income and consequently not considered to be ECI subject to U.S. income tax.

The Tax Court ruling does not affect the tax treatment of gain attributable to U.S. real property interests being treated as ECI under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) rules to the extent attributable to U.S. real property interests or the taxable treatment of a non-U.S. partner's allocable share of ECI generated by a partnership.


The long-awaited Tax Court ruling in the Grecian Magnesite case could have far-reaching implications. Because of the IRS' position in Revenue Ruling 91-32, a common structuring alternative for non-U.S. investors in a U.S. partnership has been to use a U.S. blocker structure to avoid recognizing ECI upon the sale or redemption of the partnership interest. Under the Grecian Magnesite result, using a U.S. blocker entity would not be as appealing or necessary. In the case of a U.S. partnership holding insignificant U.S. real property assets, a non-U.S. investor could instead invest directly in the partnership, bypassing the extra complexity and costs associated with a blocker structure. However, considering that the Grecian Magnesite decision may be appealed, and could be reversed on appeal, taxpayers should rely on the case at this time with caution.

Moreover, the Grecian Magnesite decision could also be affected by a legislative response. The Treasury Department under the Obama administration had proposed to codify the ruling position of Revenue Ruling 91-32, but no legislation or Treasury Regulations have yet addressed that position, and the Trump administration has not addressed the issue.

Finally, it is possible that a future court (or the Circuit Court on appeal) could modify Grecian Magnesite by imposing an "aggregate theory" to treat a partnership's "hot assets" as ECI. In analyzing the general "capital gain" rule of Section 741 for gains resulting from the disposition of personal property, the Tax Court in Grecian Magnesite noted that Section 751 was an express exception requiring ordinary income treatment for gains attributable to "hot assets" such as unrealized receivables, inventory, or depreciable personal property. The Tax Court did not consider it further, however, because the IRS did not assert that Section 751 applied. Although the Grecian Magnesite case did not address the appropriate taxation of partnership gain attributable to "hot assets," subsequent courts could apply Section 751 and its "aggregate theory" approach to view a similar disposition by a non-U.S. partner as a sale of that partner's allocable share of the partnership's "hot assets."


1 Although the taxpayer's interest was redeemed in Grecian Magnesite, the U.S. federal income tax consequences of a sale versus a redemption under these facts are substantially identical.

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