Tax Court Reverses Decades-Old Policy on Foreign Partner Taxation

Chris Gaetano
Published Date:
Aug 1, 2017

A tax court recently ruled that when a foreign partner redeems its partnership interest from a U.S. entity, then the resultant income counts as a capital gain not connected to U.S.-sourced income, and therefore is not taxable, overturning decades of IRS policy saying that it was. The case concerned a Greek mining company called Grecian Magnesite Mining, Indus. & Shipping Co., which bought a partnership stake in a U.S.-based chemical company called Premier in 2001. Premier regularly allocated income to Grecian until 2008, when it moved to buy another company, IMin Partners. The agreement obligated Premier to offer to purchase each partner's interest for the same pro-rata price it had paid IMin. Grecian was the only one to sell. 

Through the sale, Grecian realized a $6.2 million gain, of which it conceded that $2.2 million was attributable to U.S. real property interests and therefore taxable. The IRS, however, said that the company should have recognized U.S.-source capital gain net income of $1 million for 2008 and $5.2 million for 2009 from the redemption of its interest in Premier. The IRS said that, because of Grecian's membership interest in Premier, GMM’s capital gain was effectively connected with a trade or business engaged in within the United States.

It based this argument on Revenue Ruling 91-32, which treats gain from the sale of an interest in a partnership by a foreign partner as effectively connected income with a US trade or business where the partnership was engaged in a U.S. trade or business. The IRS argued that The gain Grecian realized in 2008 and 2009 represents Grecian’s
share of the appreciation in value of Premier’s business resulting from Premier’s efforts to improve Premier’s profits during Grecian’s tenure as a partner. As such, the gain is attributable to Grecian’s U.S. offices and is subject to U.S. tax.

However, the court said that the revenue ruling "lacks the power to persuade" and added that "its treatment of the partnership provisions... is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of 'gain or loss from the sale or exchange of the partnership interest.'" Thus, the court chose to ignore 91-32 and use only the tax code as its guide. 

In doing so, the court concluded that the activities of Premier's U.S. office were not a material factor in the redemption transfer itself, and instead was simply a factor in ongoing, distributive share income from regular business operations. The creation of value, it said, is distinct from income gains of a specific transaction. Increasing the value of Premier’s business as a going concern, without a subsequent sale, would not have resulted in the realization of gain by Grecian, according to the court. 

"Since we have held that GMM’s disputed gain on its redemption was not attributable to a U.S. office or other fixed place of business, it is therefore not U.S.-source income under section 865(e)(2)(A)," said the court. 

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