In a recent decision (Grecian Magnesite Mining, Industrial & Shipping Co., SA,v. C.I.R., 149 T.C. No.3), the Tax Court rejected the tenet of Rev. Rul. 91-32 as adopting an aggregate theory underlying the sale of a partnership interest by a foreign partner. In so holding, the Court ruled in favor of the taxpayer that the disputed gain realized upon the redemption of their interest in a U.S. partnership was not subject to U.S. income tax.
The case was highly anticipated as a test of the Service's highly controversial position adopted in Rev.Rul.91-32. Since its issuance many years ago, many professionals and taxpayers had disagreed with its basic premise. The Ruling adopted the aggregate approach regarding the sale of a partnership interest by a foreign partner. That is, the reference must be made to the assets of the partnership as compared to a sale of the partnership interest (the entity approach). If the assets generated ECI (effectively connected income) from a U.S. trade or business, then the foreign partner would be subject to U.S. tax on their portion of the attributable gain.
Grecian is a foreign corporation that had invested in a U.S. partnership. It was redeemed out by the partnership. Grecian conceded that a portion of the gain was subject to U.S. tax to the extent that the redemption proceeds pertained to the sale of the partnership’s U.S. real property interests. The balance of the gain is the disputed gain. The Court held that the disputed gain was neither U.S. source income nor ECI.Accordingly, Grecian was not subject to U.S. tax on the disputed gain.
The Service's finding of a U.S. tax liability was based upon the determination that as a result of Grecian's interest in the U.S. partnership, its capital gain constituted ECI. The Tax Court, in a well-reasoned opinion, rebutted this conclusion.
The Court acknowledged the intersection of two distinct areas of tax law; that of partnership taxation (Subchapter K of the Code) and that of international transactions (Subchapter N of the Code).
Regarding the first tax area, Grecian relied on Sec.741 to establish that the gain on liquidation is capital gain. It also cited the Tax Court's decision in Pollack (Pollack v. Commissioner 69 T.C. 142 (1977)), that the entity theory must be applied.
Grecian argued that the redemption must be respected as an indivisible item of intangible personal property and should not be recharacterized as a sale of the separate interests in each asset owned by the partnership. In essence, the inferred entity approach pursuant to the general principles of Sec. 741 must apply.
While the Service acknowledged the general tax principles, it argued that the aggregate theory nonetheless should be employed. It further argued that Sec. 741 must be reconciled with the operation of Sec. 897 (g) holding that a sale of U.S. property interests is taxable. Therefore, this exception should render Sec. 741 as a provision only applicable to the character of the gain to be recognized; capital vs. ordinary. Accordingly, the statute should not preclude the treatment of the capital gain attributed to the sale of the partnership's underlying assets; i.e. the aggregate theory.
The court rejected this approach on four grounds. Firstly, the conflict between the Sec. 741 entity construction and the Sec. 897 (g) U.S. real property exception is exaggerated. Sec.741 explicitly provides for an exception deferring to Sec. 751 ordinary income reclassification applicable to certain "hot items”. Therefore, Sec. 741 must be viewed as a general rule and not one of absolute and universal application. The tax law is replete with general rules that contains exceptions.
Secondly, the Service did not afford appropriate literal effect to the singular wording of the phrase of “sale or exchange of a capital asset” as compared to the plural phrase of “assets”. The former phrase conforms to an entity approach.
Thirdly, if Congress had intended Sec. 741 to instead operate as a look- through provision, the exceptions of Sec. 897(g) and Sec. 751 would not have been necessary. Accordingly, the general indivisible capital asset treatment prescribed under Sec.741, subject to specifically stated exceptions, must govern in other situations.
Lastly, the Service conveniently ignores the sequence of priority that must incorporate Sec. 736(b)(1), Sec. 731(a), and then Sec. 741.The correct reconstruction therefore must be that the payment is considered as a distribution under Sec.736(b)(1) , then under Sec. 731(a) the gain is considered as arising from the sale of a partnership interest, and lastly the gain would be considered as capital pursuant to Sec. 741.
The entity theory is clearly embraced by the literal and explicit language of Sec. 731(a) referring to gain from the sale or exchange of a partnership interest. Therefore, the Court concluded that Subchapter K provides a general rule that the entity theory applies to sales and liquidating distributions of partnership interests. It identified no exception for foreign partners.
The Service relied on the Sec. 736 (b)(1) language which classifies the type of income at issue as a payment for an interest in partnership property. The Court countered that this phrase has relevance only at the beginning of the analysis and not at the end. The cited sequence of Code sections tells one what to do with such payments for tax purposes and leads one logically to the result of gain or loss from the sale or exchange of the partnership interest.
Referring back to its Pollack decision, the Court concluded that the partnership provisions mandate treating the disputed gain as from the disposition of a single asset, that of a partnership interest. The aggregate approach as relied upon in the Revenue Ruling was therefore clearly rejected by the Court.
The analysis then turned on whether the disputed gain from the sale of an indivisible capital asset was taxable as ECI under international tax provisions. Relevant to the case, the disputed gain then must be from U.S. sources to be considered as ECI.
The Court again took aim at the Revenue Ruling. The Service requested deference to the conclusion reached therein that gain similar to the disputed gain was ECI. While the three fact patterns in the Revenue Ruling specifically refer to sales or dispositions as compared to a redemption, the distinction is not deemed as material. The asset by asset analysis required by the Ruling in essence adopts a Sec. 751 look-through approach for all partnership items as compared to only those specifically enumerated in the law, such as inventory and receivables.
The Court declined deference to the Ruling. Between two extremes of interpretation of its own ambiguous regulations and improper interpretation, the Court found that the Revenue Ruling lacked the power to persuade. It found the partnership tax analysis to be cursory in the extreme and criticized the international tax analysis regarding a U.S. office. Rather, the Court stated that it would follow the Code and the regulations to determine whether the disputed gain is from U.S. sources and hence ECI, subject to U.S. tax.
Sec.865(a) provides the general sourcing rule for sales of personal property by a nonresident. Income shall be sourced to the residence of the seller. The Service, however, contends that the U.S. office rule exception as provided in Sec. 865 (e)(2) (A) should apply. If the gain was attributed to the partnership's office in the U.S., then it could be taxable in the U.S. For this purpose, the partnership's office should be deemed to be Grecian's office, as a partner.
Finding an office in the U.S., however, is only the start. One must then determine what income items are attributable to such office, by employing the principles of Sec. 864 (c)(4) & (5).There are two factors in such determination.
Is the U.S. office a material factor in the production of the income? Under Regulations, a material factor must be significant and essential, but not necessarily major. The Service posited a hypothetical sale of the partnership assets and the remittance of such proceeds to Grecian. This fiction again can only be supported by fabricating an aggregate approach, which the Court resoundedly rejected. Rather, only the income realized on the redemption (as a sale of the partnership interest) by Grecian needs to be tested. The Court easily concluded that the U.S. partnership's office was not a material factor in the redemption itself. The Service's hypothetical argument misses the mark as under the entity theory, the fact that the partnership's office is a material factor in the ongoing operational activities is irrelevant to the singular redemption transaction at issue.
The Court also countered the Service's alternative argument that the partnership, by increasing the value of Grecian's partnership interest, therefore played an essential economic role in Grecian's realization of gain upon redemption. The Court sided with the taxpayer's regulatory interpretation that the creation of value is simply a distinct function from being a material factor in a specific transaction. Accordingly, the Court did not share in the opinion that the partnership's contributions to an increase in its overall value should be considered as an essential economic element in the realization of the redemption. Further, the Regulations provides that adding value alone is not sufficient. In addition, one must look to the role of the office in the transaction. Mere clerical functions incident to the sale (which reasonably describes the U.S. partnership's role) could invalidate a material factor assertion, even in the finding of adding value.
The second requirement of the U.S. source income attribution rules is whether the income was realized in the ordinary course of the trade or business which is carried on through the U.S. office.
The Court again sided with the taxpayer that the redemption was a one-time and extraordinary event and therefore was not undertaken in the partnership’s' ordinary course of business. The partnership was in the business of selling and producing magnesite and not that of buying and selling partnership interests. This fact in and of itself was sufficient for the Court to then hold that this test was also not met. Accordingly, the Court determined that the disputed gain was not attributable to a U.S. office and therefore it is not U.S. source income and consequently not considered as ECI, subject to U.S. income tax, pursuant to Sec. 882.
It is not clear whether the Service will appeal the Tax Court decision. Since they were so invested in the enunciated position of Revenue Ruling 91-32, they very well might. But, the Tax Court's reasoning and reliance on tax law was strong and well thought out. Many of the arguments posed by the Tax Court had been previously expressed by tax professionals. The Service could have a hard road to follow so as to persuade a higher court to overturn the Tax Court's decision.
Please contact an International tax group member so as to provide further insights and planning opportunities regarding this extremely significant decision.