A recent United States Tax Court case may allow foreign partners to legally avoid paying U.S. income tax on certain income from sale of its interest in a partnership (including LLC’s taxed as a partnership) that engages in a trade or business in the United States. They may even be able to get refunds if they paid taxes to the IRS on such income in prior years. This is the principal takeaway from the Tax Court’s 50-page opinion involving the tax treatment of a foreign partner’s disposition of its entire interest in a U.S. partnership.
A nonresident alien individual or foreign corporation is generally subject to U.S. income tax on only three types of income: (1) income that is “effectively connected with the conduct of a trade or business in the U.S.” (“ECI”) (2) U.S.-source income (other than ECI) that is considered to be fixed or determinable annual or periodical (“FDAP income”), such as interest on bonds issued by U.S. borrowers, and (3) gain from the disposition of a U.S. real property interest is generally treated as ECI subject to U.S. tax under provisions of a law known as “FIRFPTA.” Under these rules, a foreign partner is considered to be engaged in any U.S. trade or business in which the partnership is engaged. Thus, a foreign partner's distributive share of net ECI of the partnership is taxed under the general IRC provisions applicable to U.S. citizens and residents.
In the case of a sale or exchange of an interest in a partnership, generally gain or loss shall be recognized to the transferor partner and such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset (thus, capital gain), except that certain gain may be treated as ordinary income, e.g., gain relating to unrealized receivables and inventory items. This capital gain treatment is similar to the rule that applies to a sale of stock of a corporation. A foreign investor’s capital gain is generally not subject to U.S. tax unless certain exceptions apply.
The IRS Position on the Taxability of Dispositions of Partnership Interests by Foreign Partners
In Revenue Ruling 91-32, the IRS took the position that a foreign partner’s sale or other disposition of an interest in a partnership doing business in the U.S. would be taxed as if the foreign partner had sold its proportional shares in the partnership’s assets. Under this approach, if a sale of assets by the partnership would have created taxable ECI, the foreign partner would have to pay tax on its share of that hypothetical gain as if the foreign partner had sold those assets directly. To the extent that the partnership would have had non-ECI gain or loss on a sale of all its assets, the foreign partner’s share of such gain or loss would be ignored for U.S. tax purposes. The IRS relied on this Ruling in its attempt to impose U.S. tax on the taxpayer in this case, titled Grecian Magnesite Mining, etc. Co., S.A. v. Commissioner of Internal Revenue.
The Taxpayer’s Position in Court
Grecian Magnesite Mining (the taxpayer) was a foreign corporation that owned an interest in Premier, a U.S. LLC taxed as a partnership. In years prior to 2008, the taxpayer filed U.S. income tax returns and properly reported and paid tax on its share of taxable ECI from Premier. In 2008, the taxpayer completely disposed of its interest in Premier by selling it back to Premier in a redemption transaction. For 2008, the taxpayer filed a U.S. return and reported only its pre-disposition share of Premier’s income. The IRS, relying on its position in Revenue Ruling 91-32, claimed that the taxpayer was also liable for U.S. tax on the gain realized on the disposition of the taxpayer’s interest in Premier. Although the taxpayer conceded it was taxable on the portion of that gain attributable to its interest in Premier’s U.S. real property (under the FIRPTA rules), the taxpayer challenged the correctness of the ruling and claimed that the balance of the gain was not taxable by the U.S.
The Tax Court Sides with the Taxpayer and Rejects the Analysis in Revenue Ruling 91-32
In July 2017, in a stunning defeat for the IRS, the Tax Court issued a Taxpayer-favorable decision and held that the IRS position set forth the 26-year-old ruling wrong. As a result, the taxpayer's gain (other than gain under the FIRPTA rules) on the complete disposition of its interest in Premier wasn’t subject to U.S. tax.
The Grecian Mining decision may be appealed by the IRS, so the law on this issue is still subject to uncertainty. Nevertheless, foreign partners who realize a significant gain in 2017 on the sale or other disposition of an interest in a U.S. partnership should consider taking the position that the gain is not subject to U.S. tax. In addition, foreign partners who have already paid U.S. taxes on a sale or redemption of a U.S. partnership interest in 2014 through 2016 (and other taxable years that are still “open” under the statute of limitations) should consider filing refund claims to preserve their rights if the Tax Court’s decision is not appealed or is sustained on appeal.
The U.S. tax law and rules in this area are highly complex. Taxpayers should seek advice from competent tax advisors to determine how the rules and the Grecian Mining decision could apply to their unique facts and circumstances. The Tax Warriors at D&S are available to assist with that analysis, contact us.