U.S. Tax Court Rules Disposition of U.S. Partnership Interest by Foreign Partner is Not U.S. Source Income
July 21, 2017
By Philip Brudney, manager, and Ethan Deng, senior tax associate
A new Tax Court decision marks a major shift in the tax consequences of the disposition of a U.S. partnership interest by a foreign partner.
Until now, the disposition of a U.S. partnership interest by a foreign partner was governed by IRS Revenue Ruling 91-32. Under the ruling, the aggregate approach to partnerships was applied. Therefore, the U.S. business of a U.S. partnership would be attributed to the foreign partner, and the partner’s sale of his partnership interest would be deemed as a sale of partnership assets. The sale of assets would be effectively connected to the U.S.; thus, the gain on sale of the partnership interest would also be U.S. source income and be subject to U.S. tax.
On July 13, the U.S. Tax Court ruled on Grecian Magnesite Mining, a controversial case regarding the sourcing of gain on the redemption of U.S. partnership by a foreign partner, and reversed the IRS’s ruling in Revenue Ruling 91-32.
Grecian Magnesite Mining, Industrial & Shipping Co. (GMM) is a foreign corporation and partner in a U.S. limited liability company, Premier Chemicals, LLC (PC). GMM purchased an interest in PC in 2001. It had been reporting income from the partnership and paid U.S. income taxes. In 2008, GMM’s interest in the partnership was redeemed by PC, and it received two liquidating payments totaling $6.2 million. $2 million was taxable in the U.S. as it related to a real property interest, but GMM believed the remaining $4.2 million was not U.S. source income and, therefore, not taxable in the U.S.
IRC Sections 864 & 865 provide that for a sale to be attributed to a U.S. office (U.S. source income), it must be shown that the U.S. office is the material factor for the generating of such underlying income and such income generating activities are in the ordinary course of business. GMM argued that the sale of its interest in PC was not in the ordinary course of PC’s business and it was a one-time extraordinary event; therefore, it should not be sourced as U.S. income.
Ruling in favor of the taxpayer and the entity approach to partnership taxation, the Tax Court determined that the sale was not effectively connected with a U.S. trade or business and, therefore, was not U.S. source income. As a result, a foreign partner not otherwise engaged in a U.S. trade or business would generally not be subject to U.S. income tax on the sale of a U.S. partnership interest. The tax court explicitly rejected the IRS’s argument under Revenue Ruling 91-32, saying the ruling was too general and did not address key issues.
The IRS has not issued a response since the ruling on July 13. In the current regulatory environment, it is hard to say if the IRS or the Congress will come out with new regulations to diminish or override the court ruling. We will be watching for future developments surrounding this question, but for the time being, this court ruling has clearly stated that disposition of U.S. partnership interest by foreign partner is not U.S. source income.
Questions about disposition of U.S. partnership? Contact Philip Brudney at [email protected].
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