Overview
On July 13, the Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 T.C. No. 3, rejected the IRS’s approach for determining whether income from the disposition of a partnership interest is effectively connected with a US trade or business. The court refused to defer to the IRS’s approach to the issue in Rev. Rul. 91-32, 1991-1 C.B. 107, stating that the ruling “lacks the power to persuade” and criticizing its discussion of the partnership rules as “cursory.”
Facts
In 2001, Grecian Magnesite Mining (GMM), a Greek corporation, purchased an interest in Premier Chemicals, LLC (Premier), a US limited liability company engaged in the conduct of a US trade or business treated as a partnership for US income tax purposes. In 2008, GMM, a cash-basis taxpayer, agreed to have its interest redeemed by Premier. GMM received two liquidating payments, one in 2008 and one in 2009. Premier and GMM agreed that the effective date of the transfer was December 31, 2008. In the redemption, GMM realized gain totaling more than $6.2 million. GMM filed a 2008 Form 1120-F reporting its distributive share of Premier’s income, gain, loss, deductions, and credits, but, pursuant to advice from its attorney/CPA, did not report any of the gain from the redemption. GMM did not file a return for 2009, also pursuant to advice from its attorney/CPA.
On audit, the IRS asserted that GMM had US source gain in both 2008 and 2009 that was effectively connected with a US trade or business. GMM subsequently conceded that a portion of the gain realized from the first payment in 2008 and the second payment in 2009 was attributable to the sale of a US real property interest and considered US-source effectively connected income (ECI) under the Foreign Investment in Real Property Act (FIRPTA) rules, specifically section 897(g). As a result, only the ECI issues with respect to the remaining disputed portion of the gain from the redemption proceeds were before the Tax Court.
Revenue Ruling 91-32
The IRS based its position, in part, on Rev. Rul. 91-32, which analyzed three fact patterns where a foreign partner recognizes gain upon disposition of a US partnership interest. Adopting an “aggregate theory” approach, the ruling holds that the gain realized by a foreign partner on the sale or disposition of its interest in a partnership engaged in a trade or business through a fixed place of business in the United States should be analyzed asset by asset, and that, to the extent there would be ECI with respect to asset sales, the selling partner’s pro rata share of such gain should be treated as ECI.
Tax Court Decision
The court began by analyzing the partnership tax rules, concluding that, pursuant to section 736(b)(1), payments made in redemption of GMM’s interest should be considered a distribution and that, pursuant to section 731(a), any gain or loss should be considered as gain or loss from the sale of exchange of the partnership interest. Section 741 provides a general rule that, in the case of a sale or exchange of an interest in a partnership, gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset. Based on the text and structure of the provisions of subchapter K, the court adopted an “entity theory” approach, concluding that the disputed portion of the redemption proceeds should be treated as gain from the sale or exchange of “a singular capital asset.” (The court noted statutory exceptions, including those in sections 751 and 897(g).)
The court then turned to the international tax rules to determine whether that gain was taxable, specifically as US-source ECI. The court first stated that it would not defer to the IRS’s approach in Rev. Rul. 91-32, which “is not simply an interpretation of the IRS’s own ambiguous regulations, and . . . lacks the power to persuade.”
The court then analyzed whether the gain was US source. Under the general rule in section 865(a), income from the sale of personal property by a nonresident is sourced outside the United States. The IRS argued, however, that section 865(e)(2)(A) applied. That provision states that, if a nonresident maintains an office or other fixed place of business in the United States, income from any sale of personal property attributable to such office or other fixed place of business shall be sourced in the United States. Section 865(e)(3) further states that “the principles of section 864(c)(5)” apply in determining whether a taxpayer has an office or other fixed place of business and whether a sale is attributable to such an office or other fixed place of business. Under section 864(c)(5)(B), income, gain, or loss is attributable to a US office only if the US office is “a material factor in the production of such income” and the US office “regularly carries on activities of the type from which such income, gain, or loss is derived.”
The IRS argued that the disputed gain from the redemption was attributable to Premier’s US office (which the court assumed, without holding, was GMM’s office) because the activities in that office were ultimately responsible for the increased value of the GMM’s partnership interest in Premier that was realized in the redemption. However, based on its interpretation of regulations under section 864, the court concluded that, for the disputed gain to be attributable to a US office, that office’s activities “must be material to the redemption transaction itself and the gain realized therein, rather than simply being a material factor in ongoing, distributive share income from regular business operations.”
Furthermore, the court concluded that the disputed gain was not realized in the “ordinary course” of Premier’s business conducted through its US office because GMM’s redemption transaction was part of a “one-time, extraordinary event.”[1]
Penalties
The IRS also asserted that GMM owed an accuracy-related penalty for 2008 with respect to the FIRPTA gain and failure-to-file and failure-to-pay additions to tax for 2009. The court concluded that GMM had reasonable cause for the errors and failures because it relied in good faith on a mistaken legal opinion of a competent tax adviser. The court noted that GMM’s attorney/CPA was not an international tax expert but concluded that he had “sufficient credentials,” including 40 years of experience preparing income tax returns, to justify GMM’s reliance.
Concluding Thoughts
The Tax Court opinion follows decades of practitioner criticism of Rev. Rul. 91-32. However, the decision may not be the final word on the issue. The IRS may appeal. A legislative response is also possible. In the last several years of the Obama Administration, Treasury proposed a rule providing that gain or loss from the sale or exchange of a partnership interest would be treated as ECI to the extent attributable to the transferor partner’s distributive share of the partnership’s unrealized gain or loss that is attributable to ECI property. The Obama Greenbook proposal also included a FIRPTA-like withholding regime with respect to the sale or exchange of a partnership interest. The Trump Administration has not yet addressed the issue.
[1] The Tax Court subsequently issued an order correcting an erroneous statutory citation in the original opinion and providing some additional clarification.
