Updated August 2017
On July 13, 2017, the U.S. Tax Court released Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner, 149 T.C. No. 3 (July 13, 2017) (available here), in which it declined to follow the IRS’s position in Revenue Ruling 91-32, 1991-1 C.B. 107 (the “Ruling”). In the Ruling, the IRS held a non-U.S. person’s gain from the disposition of an interest in a partnership engaged in a U.S. trade or business is income that is effectively connected to a U.S. trade or business and, thus, subject to U.S. federal income tax. This case has implications for foreign investors contemplating investments in partnerships with U.S. business activities (apart from investments in U.S. real property interests).
Gain recognized from the disposition of an interest in a partnership is generally capital gain. Under the Internal Revenue Code of 1986, as amended (the “Code”), capital gain recognized by a non-U.S. person (such as a non-resident alien or foreign corporation) is generally not subject to U.S. federal income tax unless it is effectively connected with such non-U.S. person’s conduct of a U.S. trade or business (“ECI”). Capital gain of a non-U.S. person generally will be ECI only if such gain is attributable to a U.S. office or fixed place of business through which such non-U.S. person conducts a U.S. trade or business (a “U.S. Office”). Such gain would generally be attributable to a U.S. Office only if the activities of such office were a material factor in the production of such gain and the office regularly carries on activities of the type from which such gain is derived.
2. The Ruling
The Ruling concludes that gain recognized by a non-U.S. person from the disposition of an interest in a partnership will be deemed attributable to a U.S. Office of the non-U.S. person to the extent that such non-U.S. person’s distributive share of unrealized partnership gains would be attributable to ECI. Its conclusion seems to rely on an aggregate theory of taxation of dispositions of interests in a partnership whereby the non-U.S. person is treated as selling, through the U.S. Office of the partnership, its proportionate share of the partnership’s assets. The Ruling has often been criticized by commentators as being inconsistent with the Code provisions that generally treat a partnership as an entity, except in limited circumstances (for example, when the partnership holds unrealized receivables or U.S. real property interests).
3. Grecian Magnesite Mining
Grecian Magnesite Mining, Industrial & Shipping Co., S.A. (“GMM”), the taxpayer in the case before the Tax Court, owned an interest in an entity, which at the time was organized as Premier Chemicals, LLC (“Premier”). GMM had no office, employees or business operations in the United States other than through its ownership interest in Premier, which was classified as a partnership for U.S. federal income tax purposes. Premier was engaged in a U.S. trade or business through its ownership interests in various industrial properties in the United States. GMM’s ownership interest in Premier was redeemed for $10.6 million, resulting in $6.2 million of gain. The IRS contended that, under the Ruling, $4 million of that gain was ECI and subject to U.S. federal income tax.
As a matter of administrative law, the Tax Court declined to defer to the Ruling. The Tax Court stated that it only defers to revenue rulings where such rulings interpret the IRS’s own ambiguous regulations. When a revenue ruling does not interpret ambiguous regulations, such a ruling is afforded weight only to the extent of its power to persuade. In this case, the Tax Court was not persuaded by the Ruling and found that a proper interpretation of the Code and regulations led to a contrary conclusion.
The Tax Court examined the Code provisions governing dispositions of partnership interests and found that such provisions generally employed the entity theory of taxation of dispositions of interests in a partnership, with special aggregate theory carve-outs for certain situations. The Tax Court concluded that the Ruling and the IRS’s position in the litigation would render such exceptions unnecessary. Furthermore, the Tax Court concluded that, even though a U.S. Office may be a material factor in the ongoing, distributive share income from regular business operations, such a fact is insufficient to transform gain from the redemption of a partnership into income attributable to that office. Also fatal to the IRS argument was the fact that the redemption at issue was not made in the ordinary course of the partnership’s business. Therefore, the Tax Court held that the redemption of GMM’s interest in Premier was not ECI subject to U.S. federal income tax.
The Tax Court’s decision does not alter the treatment of a foreign partner’s distributive share of ECI earned by the partnership (including ECI gain realized by the partnership from a disposition of partnership assets). Similarly, the Tax Court’s decision does not alter the treatment under the FIRPTA rules of a foreign partner’s gain on the disposition of an interest in a partnership that holds U.S. real property interests.
Historically, non-U.S. persons have employed a blocker structure to invest in partnerships or other pass-through entities that are engaged in the conduct of a U.S. trade or business (“Pass-Through Operating Entity”) whereby the foreign investor holds its interests in the Pass-Through Operating Entity through an entity treated as a corporation for U.S. federal tax purposes (a “Blocker”). Such a structure allows the foreign investor to avoid the recognition of ECI and avoid U.S. federal income tax reporting and compliance requirements with respect to its investment. Instead, the Blocker is subject to entity level income taxation and U.S. federal income tax reporting and compliance requirements. Blockers typically have been corporations that are formed/organized in the United States (“Domestic Blockers”) in order avoid branch profits tax, which generally is imposed on a foreign corporation’s U.S. earnings and profits at a 30% rate, but such rate is reduced in most cases to 5% if the foreign corporation is eligible for treaty benefits. In order to lessen the amount of entity level income tax, Domestic Blockers are oftentimes capitalized by their investors with debt (which generates interest deductions for the Domestic Blocker) as well as equity capital.
The Tax Court’s holding in the Grecian Magnesite case is likely to have one or more of the following implications:
- Foreign investors that have disposed of interests in a Pass-Through Operating Entity in the past 3 to 4 years and have paid U.S. federal income tax on the gain as ECI should consider filing refund claims before applicable statutes of limitation expire.
- A Domestic Blocker (or, in certain cases, a Blocker formed as a REIT) may continue to be the preferred vehicle for foreign investors that are investing in Pass-Through Operating Entities that own a material amount of U.S. real property interests since gain from the sale of interests in such Pass-Through Operating Entities continue to be treated as ECI under the FIRPTA rules.
- A foreign investor may consider investing directly in the Pass-Through Operating Entity if (i) the foreign investor is willing to satisfy the U.S. federal income tax reporting and compliance requirements, and (ii) if the foreign investor is a corporation, it is eligible for treaty benefits that will reduce the branch profits tax rate.
- Foreign investors that do not want to satisfy U.S. federal income tax reporting and compliance requirements directly may wish to invest in Pass-Through Operating Entities through a Blocker formed/organized outside the United States (“Foreign Blocker”). A Foreign Blocker may be more tax efficient than a Domestic Blocker if either (i) the Foreign Blocker is eligible for treaty benefits that reduce the branch profits tax rate or (ii) the amount of ECI allocated to the Foreign Blocker is expected to be relatively small as compared to gain on the sale of the interest in the Pass-Through Operating Entity.
- Foreign investors may want to continue investing in Pass-Through Operating Entities through Domestic Blockers in cases where branch profits taxes are expected to be significant, the Domestic Blocker can be capitalized with a sufficient amount of debt so as to materially reduce its expected taxable income and/or the ultimate exit event is likely to consist of a sale of equity of the Domestic Blocker (as opposed to a sale of interests in or the operating assets of, or equity interests in, the Pass-Through Operating Entity).
Notwithstanding the foregoing discussion, we caution that the IRS may appeal the Tax Court’s ruling. In addition, the IRS may non-acquiesce in the holding of the case and may continue to take a contrary approach in audits and litigation.
This update is intended only to provide a general summary of certain tax provisions and not to constitute tax advice for any particular situation. If you have any questions about any of these tax provisions or their applicability to your particular circumstances, please contact us.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of more than 700 lawyers practicing throughout a network of 13 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy, technology, and life sciences sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.