01 Sep Redemption of a Foreign Partner’s Interest May Escape U.S. Taxation
The U.S. Tax Court issued an opinion on July 13, 2017 that gives an international dimension to the debate regarding the entity approach and aggregate approach of partnerships. The entity approach conceives a partnership as a legal entity that is separate and distinct from the partners themselves, while the aggregate approach conceives a partnership as the mere aggregation of its partners with no separate legal status. Previously, this area of law was applied domestically. The new Tax Court opinion shows how these approaches can lead to different results when applied internationally.
In Grecian Magnesite Mining v. Commissioner, the U.S. Tax Court declined to follow IRS Revenue Ruling 91-32, which treats gain from the sale of an interest in a partnership by a foreign partner as “effectively connected income” where the partnership was engaged in a U.S. trade or business. Instead, the Court held the gain from the sale of an interest in a partnership by a foreign partner is not effectively connected income with a U.S. trade or business. As a result, the foreign partner, in this case, was not liable for U.S. income tax even though the gain came from the redemption of a foreign partner’s interest in a U.S. partnership.
In the case, Grecian Magnesite Mining (“GMM”), a Greek corporation which sells magnesia and magnesite to customers around the world, realized $6.2 million of gain from the redemption of its interest in a U.S. company, Premier Magnesia, LLC (“Premier”). Both companies were partners in a U.S. partnership. The IRS issued a notice of deficiency to GMM because it did not pay any U.S. federal income tax on the gain. At trial, the issue was whether the gain was effectively connected with a U.S. trade or business under Internal Revenue Code section 882, and thus, whether it was considered U.S. source income.
To source the income in the U.S., the IRS used the “U.S. office rule” in Code Section 865(e)(2)(A) which states that “if a non-resident maintains an office or other fixed place of business in the U.S., income from any sale of personal property attributable to such office or other fixed place of business” is U.S. source income. In order to determine whether income from a sale is attributable to a U.S. office or fixed place of business, Revenue Ruling 91-32 states that income, gain, or loss is attributable to a U.S. office if the U.S. office or fixed place of business is a material factor in the production of income, and if it regularly carries on the type of activities from which such income is derived.
The IRS alleges that Premier’s office in the U.S. was a material factor in the production of income with regards to the deemed sale of GMM’s portion of partnership assets and also to the increased value of Premier that GMM realized in the redemption. However, the Tax Court has a completely different point of view. It considers the IRS’ view to be incorrect in the sense that it envisions an aggregation theory of partnerships while the Court decided the entity approach was applicable to the redemption.
Indeed, the Tax Court emphasized that “one way of describing the dispute in this case is to say it raises the question whether, as to a foreign partner’s liquidation of its interest in a U.S. partnership, the entity approach applies […] so that the gain arises from the sale of a single asset (i.e., GMM’s interest in the U.S. partnership), or instead the ‘aggregation’ approach applies […], so that the gain arises from the sale of GMM’s interest in the assets that make up the partnership’s business […]”
The Court held that Revenue Ruling 91-32 does not analyze the question of when an office or other fixed place of business might be a material factor in the production of redemption gain. It only applies in the non-redemption context. Moreover, the Court said that the office had not increased the value of GMM’s interest. While it is true that it may have increased the value of the business of Premier, this is not relevant in the redemption context. From the Court’s perspective, the IRS conflated the ongoing value of a business operation with gain from the sale of an interest in that business.
The implications of the Tax Court decision will depend on whether the decision is affirmed on appeal. If the decision is affirmed then it may open significant structure and planning opportunities for foreign investors in the U.S.
 Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3, 16 (2017).