Non-US investor held not taxable on ECI partnership sale

Overview

In a decision released on July, 13, 2017, the US Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 T.C. No. 3 (2017) (“Grecian”), held that a non-US partner’s gain from the redemption of an interest in a partnership that was engaged in a US trade or business (“USTB”) was not subject to US federal income tax as effectively connected income (“ECI”), except with respect to the portion of the gain attributable to the non-US partner’s share of the partnership’s US real property interests.  In doing so, the Tax Court declined to follow IRS Revenue Ruling 91-32, 1991-1 C.B. 107 (“Rev. Rul. 91-32”), which held that a non-US partner’s gain on the sale of an interest in a partnership is ECI, and therefore is subject to US federal income tax, to the extent the gain is attributable to the partnership’s USTB.

Rev. Rul. 91-32 relied on an “aggregate” theory of partnerships, treating a sale of a partnership interest in effect as a sale of an undivided interest in the partnership’s assets.  This IRS position was controversial, but had not previously been challenged in court.  The Tax Court in Grecian, in rejecting Rev. Rul. 91-32, held that absent an explicit exception, the “entity” theory of partnerships should apply, under which a partner is treated as owning an interest in an entity that is separate and distinct from an interest in the underlying assets.  Because Congress explicitly carved out exceptions to the aggregate theory in narrow circumstances, such as Section 751¹ (providing for ordinary income treatment on a sale of a partnership interest to the extent attributable to certain of the partnership’s ordinary income assets) and Section 897(g) (treating the disposition of an interest in a partnership as ECI to the extent gain is attributable to US real property interests), the court reasoned that “[t]he partnership provisions in subchapter K of the Code provide a general rule that the ‘entity theory’ applies to sales and liquidating distributions of partnership interests—i.e., that such sales are treated not as sales of underlying assets but as sales of the partnership interest.”  Applying the entity theory approach, the court determined the capital gain from the redemption of Grecian’s partnership interest was not ECI and therefore not taxable for US federal income tax purposes.

It should be noted that the Obama Administration proposed codifying Rev. Rul. 91-32, and the US Treasury Department had announced its intent to issue regulations applying the principles of Rev. Rul. 91-32, although legislation was never adopted and regulations have not been promulgated. 

Potential impact of Grecian

Non-US investors in partnerships conducting a USTB often participate through “blocker” structures, typically US corporations, to insulate them from ECI and the resulting direct US tax filing and payment obligations. US corporate blockers are subject to US taxation on their income from partnerships, as well as on any gain from a sale of the partnership interest. To avoid corporate level gain on the sale of a partnership interest, blockers often seek to sell the stock in the blocker, although such a sale does not allow the buyer a step-up in the basis of the partnership’s assets.  It may be expected that the IRS will appeal Grecian and express its intent not to follow the decision.  However, if the Grecian decision is upheld, non-US investors will likely reexamine the use of blockers, with the potential to increase the use of foreign blocker corporations that will not be subject to US taxation on the sale of partnership interests under Grecian.

Even prior to any IRS appeal, Grecian represents a significant shift that may enable non-US partners disposing of interests in partnerships engaged in a USTB to consider whether their gain is not subject to US federal income tax.  Further, non-US persons that have treated a sale of a partnership interest as ECI based on Rev. Rul. 91-32 should consider whether to seek a refund for taxes paid for any open tax years. 

¹ All “Section” references are to the Internal Revenue Code of 1986, as amended (the “Code”).