The window for non-U.S., or foreign, investors to claim they are not subject to U.S. tax on gains stemming from the disposition of an interest in a U.S. partnership remains open. On June 11, 2019, the D.C. Court of Appeals ruled in favor of the taxpayer in Grecian Magnesite Mining Industrial & Shipping Co. SA v. Commissioner, upholding a July 13, 2017, decision by the Tax Court. The Court of Appeals decision could be significant for foreign investors in U.S. partnerships who took a position contrary to Revenue Ruling 91-32 prior to the enactment of the Tax Cuts and Jobs Act (TCJA).
Revenue Ruling 91-32 Pre-TCJA
Prior to the TCJA there was uncertainty about whether or not a foreign partner investing in a U.S. partnership engaged in a U.S. trade or business faced potential U.S. tax exposure if the partnership was disposed of at a gain. Under Revenue Ruling 91-32, it seemed the foreign partner would be liable for U.S. tax. Specifically, the ruling states that any gain or loss from the disposal of a partnership interest — where the underlying activity came from a fixed place of business in the U.S. — would be considered effectively connected income (ECI) from a U.S. trade or business and subject the foreign partner to U.S. tax.
As a result, since this 1991 ruling non-U.S. partners have taken a position contrary to this ruling under the entity theory of partnership taxation, typically arguing the IRS ruling was not supportable given current law. Using the entity approach, the gain or loss from the disposition of the partnership interest would be viewed as gain or loss on the disposition of the entity (the U.S. partnership) rather than the disposition of an undivided interest in the underlying assets of the partnership (the position of the IRS in Revenue Ruling 91-32). This way, foreign partners would not pay U.S. income taxes and U.S. branch profits tax on the disposition of an interest in a U.S. partnership.
Courts Object to Revenue Ruling 91-32
The U.S. Tax Court weighed in on this issue in July 2017, essentially rejecting the IRS view in Revenue Ruling 91-32 as lacking the “power to persuade” under current law. On June 11, 2019, the D.C. Circuit Court of Appeals decision in Grecian upheld the Tax Court’s decision that a foreign investor’s gain from its disposition of a U.S. partnership interest is not U.S.-sourced and, therefore, not taxable under U.S. law.
The government argued on appeal that Grecian Magnesite’s disposition of its partnership interest in Premier Chemical LLC, a U.S. partnership, should be sourced to the United States under the so-called U.S. office rule in Section 865(e)(2)(A). This rule requires foreign investors to source income to the U.S. if the foreign investor maintains on office or other fixed place of business in the U.S. The government’s position was that the gain realized on disposition of Premier Chemical should be sourced to the U.S. based on the location of the activities that caused the increase in value, i.e., the U.S.
The D.C. Circuit Court’s opinion indicated the location of the disposition transaction determines the source of Grecian Magnesite’s gain under the U.S. office rule. Applying the sourcing rules of Section 864(c)(5), the Court held that the gain realized is not U.S.-source income because Premier Chemical was not in the business of partnership transactions. The opinion also followed the Tax Court’s decision to reject the IRS position in Revenue Ruling 91-32.
The Fate of Revenue Ruling 91-32 — After the TCJA
It is important to note the Tax Cuts and Jobs Act of 2017 enacted Section 864(c)(8), which reflects an aggregate approach, codifying the IRS position in Revenue Ruling 91-32. For foreign investors in U.S. partnerships that took a position contrary to Revenue Ruling 91-32 prior to the enactment of the TCJA, the D.C. Circuit Court’s opinion is significant, as it means those taxpayers can confidently maintain their position.
